Standard Costing Analysis

Section D
Standard Costing and Variances

Q1. Woodeezer Ltd makes quality wooden benches for both indoor and outdoor use. Results have been
disappointing in recent years and a new managing director, Peter Beech, was appointed to raise
production volumes. After an initial assessment Peter Beech considered that budgets had been set at
levels which made it easy for employees to achieve.
He argued that employees would be better motivated by setting budgets which challenged them more in
terms of higher expected output. Other than changing the overall budgeted output, Mr Beech has not yet
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altered any part of the standard cost card.
Thus, the budgeted output and sales for November 2002 was 4,000 benches and the standard cost card
below was calculated on this basis:
e

Wood 25 kg at 3.20 per kg 80.00
Labour 4 hours at 8 per hour 32.00
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Variable overheads 4 hours at 4 per hour 16.00
Fixed overheads 4 hours at 16 per hour 64.00
192.00
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Selling price 220.00
Standard profit 28.00
Overheads are absorbed on the basis of labour hours and the company uses an absorption costing
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system. There were no stocks at the beginning of November 2002. Stocks are valued at standard cost.
Actual results for November 2002 were as follows:

Wood 80,000 kg at 3.50 per kg 280,000
a
Labour 16,000 hours at 7.00 per hour 112,000
Variable overheads 60,000
r
Fixed overheads 196,000
Total production cost 648,000
Cost of sales
Sales (3,200 benches)
Actual profit
a i
Closing stock (400 benches at 192) 76,800
571,200
720,000
148,800
The average monthly production and sales for some years prior to November 2002 had been 3,400 units
and budgets had previously been set at this level. Very few operating variances had historically been
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generated by the standard costs used.
Mr Beech has made some significant changes to the operations of the company. However, the other
directors are now concerned that Mr Beech has been too ambitious in raising production targets. Mr
Beech had also changed suppliers of raw materials to improve quality, increased selling prices, begun to
introduce less skilled labour, and significantly reduced fixed overheads.
The finance director suggested that an absorption costing system is misleading and that a marginal
costing system should be considered at some stage in the future to guide decision-making.
Required:
(a) Prepare an operating statement for November 2002. This should show all operating variances
and should reconcile budgeted and actual profit for the month for Woodeezer Ltd. (14 marks)
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(b) In so far as the information permits, examine the impact of the operational changes made by
Mr Beech on the profitability of the company. In your answer, consider each of the following:
(i) motivation and budget setting; and
(ii) possible causes of variances. (6 marks)
Q2. Sticky Wicket (SW) manufactures cricket bats using high quality wood and skilled labour using mainly
traditional manual techniques. The manufacturing department is a cost centre within the business and
operates a standard costing system based on marginal costs.
At the beginning of April 2010 the production director attempted to reduce the cost of the bats by
sourcing wood from a new supplier and de-skilling the process a little by using lower grade staff on parts
of the production process. The standards were not adjusted to reflect these changes.
The variance report for April 2010 is shown below (extract).
Adverse Favourable
Variances $ $
Material price 5,100
Material usage 7,500
Labour rate 43,600
S
Labour efficiency 48,800
Labour idle time 5,400
The production director pointed out in his April 2010 board report that the new grade of labour required
significant training in April and this meant that productive time was lower than usual. He accepted that
the workers were a little slow at the mom
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ent but expected that an improvement would be seen in May 2010. He also mentioned that the new wood
being used was proving difficult to cut cleanly resulting in increased waste levels.
Sales for April 2010 were down 10% on budget and returns of faulty bats were up 20% on the previous
month. The sales director resigned after the board meeting stating that SW had always produced quality
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products but the new strategy was bound to upset customers and damage the brand of the business.
Required:
(a) Assess the performance of the production director using all the information above taking into
account both the decision to use a new supplier and the decision to de-skill the process. (7 marks)
In May 2010 the budgeted sales were 19,000 bats and the standard cost card is as follows:
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Std cost Std cost
$ $
Materials (2kg at $5/kg) 10
Labour (3hrs at $12/hr) 36
Marginal cost 46
Selling price 68
Contribution 22
In May 2010 the following results were achieved:
40,000kg of wood were bought at a cost of $196,000, this produced 19,200 cricket bats. No inventory of
raw materials is held. The labour was paid for 62,000 hours and the total cost was $694,000. Labour
worked for 61,500 hours.
The sales price was reduced to protect the sales levels. However, only 18,000 cricket bats were sold at an
average price of $65.
Required:
(b) Calculate the materials, labour and sales variances for May 2010 in as much detail as the
information allows. You are not required to comment on the performance of the business.
(13 marks)
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Q3. Chaff Co processes and sells brown rice. It buys unprocessed rice seeds and then, using a relatively
simple process, removes the outer husk of the rice to produce the brown rice. This means that there is
substantial loss of weight in the process. The market for the purchase of seeds and the sales of brown rice
has been, and is expected to be, stable. Chaff Co uses a variance analysis system to monitor its
performance.
There has been some concern about the interpretation of the variances that have been calculated in
month 1.
1. The purchasing manager is adamant, despite criticism from the production director, that he has
purchased wisely and saved the company thousands of dollars in purchase costs by buying the required
quantity of cheaper seeds from a new supplier.
felt he had to do something about it.
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2. The production director is upset at being criticised for increasing the wage rates for month 1; he feels
the decision was the right one, considering all the implications of the increase. Morale was poor and he
3. The maintenance manager feels that saving $8,000 on fixed overhead has helped the profitability of the
business. He argues that the machines annual maintenance can wait for another month without a
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problem as the machines have been running well. The variances for month 1 are as follows:
$
Material price 48,000 (Fav)
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Material usage 52,000 (Adv)
Labour rate 15,000 (Adv)
Labour efficiency 18,000 (Fav)
A
Labour idle time 12,000 (Fav)
Variable overhead expenditure 18,000 (Adv)
Variable overhead efficiency 30,000 (Fav)
Fixed overhead expenditure 8,000 (Fav)
a
Sales price 85,000 (Adv)
Sales volume 21,000 (Adv)
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Chaff Co uses labour hours to absorb the variable overhead.
i
Required: -
(a) Comment on the performance of the purchasing manager, the production director and the
maintenance manager using the variances and other information above and reach a conclusion as
a
to whether or not they have each performed well. (9 marks)
In month 2 the following data applies:
Z
Standard costs for 1 tonne of brown rice
14 tonnes of rice seeds are needed at a cost of $60 per tonne
It takes 2 labour hours of work to produce 1 tonne of brown rice and labour is normally paid $18 per
hour. Idle time is expected to be 10% of hours paid; this is not reflected in the rate of $18 above.
2 hours of variable overhead at a cost of $30 per hour
The standard selling price is $240 per tonne
The standard contribution per tonne is $56 per tonne
Budget information for month 2 is
Fixed costs were budgeted at $210,000 for the month
Budgeted production and sales were 8,400 tonnes
Page 3 of 106
The actual results for month 2 were as follows:
Actual production and sales were 8,000 tonnes
12,000 tonnes of rice seeds were bought and used, costing $660,000
15,800 labour hours were paid for, costing $303,360
15,000 labour hours were worked
Variable production overhead cost $480,000
Fixed costs were $200,000
Sales revenue achieved was $1,800,000
Required:
(b) Calculate the variances for month 2 in as much detail as the information allows and reconcile
the budget profit to the actual profit using marginal costing principles. You are not required to
comment on the performance of the business or its managers for their performance in month 2.
(16 marks)
(25 marks)
S
M
A
C
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Material mix and yield variance
Material mix variance arises when the mix of materials actually used differs from the predetermined mix
included in the calculation of the standard cost of an operation. When large proportion of cheaper
material included in the mixture, there will be a favourable variance and vice versa
Material yield variance arises because there is a difference between the standard output for a given level
of input and actual output attained from the same input. If actual out is greater than standard output
expected from the input then the variance yield variance is favourable.
Q1. Simply Soup Limited manufactures and sells soups in a JIT environment. Soup is made in a
manufacturing process by mixing liquidised vegetables, melted butter and stock (stock in this context is a
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liquid used in making soups). They operate a standard costing and variances system to control its
manufacturing processes. At the beginning of the current financial year they employed a new production
manager to oversee the manufacturing process and to work alongside the purchasing manager. The
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production manager will be rewarded by a salary and a bonus based on the directly attributable variances
involved in the manufacturing process
After three months of work there is doubt about the performance of the new production manager. On the
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one hand, the cost variances look on the whole favourable, but the sales director has indicated that sales
are significantly down and the overall profitability is decreasing.
The table below shows the variance analysis results for the first three months of the managers work.
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Table 1
Month 1 Month 2 Month 3
Material Price Variance $300 (F) $900 (A) $2,200 (A)
A
Material Mix Variance $1,800 (F) $2,253 (F) $2,800 (F)
Material Yield Variance $2,126 (F) $5,844 (F) $9,752 (F)
Total Variance $4,226 (F) $7,197 (F) $10,352 (F)
The actual level of activity was broadly the same in each month and the standard monthly material total
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cost was approximately $145,000.
The standard cost card is as follows for the period under review
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$
0.90 litres of liquidised vegetables at $0.80 per litre 0.72
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0.05 litres of melted butter at $4 per litre 0.20
1.10 litres of stock at $0.50 per litre 0.55
Total cost to produce 1 litre of soup 1.47
Required:
a
(a) Using the information in table 1:
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(i) Explain the meaning of each type of variances above (price, mix and yield but excluding the
total variance) and briefly discuss to what extent each type of variance is controllable by the
production manager. (6 marks)
(ii) Evaluate the performance of the production manager considering both the cost variance results
above and the sales directors comments. (6 marks)
(iii) Outline two suggestions how the performance management system might be changed to
better reflect the performance of the production manager. (4 marks)
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(b) The board has asked that the variances be calculated for Month 4. In Month 4 the production
department data is as follows:
Actual results for Month 4
Liquidised vegetables: Bought 82,000 litres costing $69,700
Melted butter: Bought 4,900 litres costing $21,070
Stock: Bought 122,000 litres costing $58,560
Actual production was 112,000 litres of soup
Required:
Calculate the material price, mix and yield variances for Month 4. You are not required to comment
on the performance that the calculations imply. Round variances to the nearest $. (9 marks)
Material mix and yield variances with losses

Q2. A company manufactures a range of fertilizers and pesticides for the farming industry. Management
have provided you with the following information for a recently developed organic fertilizer, W.
Standard cost of W
Material Quantity Price per kg Total
S
Kilos
F 32 4 128
G 20 3 60
H 28 6 168
80 356
Less: Standard losses 04
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Standard yield 76
The actual costs are as follows
Kilos
A
F 17,960 4.25 7,140
G 14,840 2.80 4,620
H 15,200 6.40 5,568
48,000 17,328
C
Less: Actual losses (4,000)
Actual yield 44,000
Required: -
Calculate total usage variance, mix and yield variance
Q3. A company makes a product using two materials, X and Y, in the production process. A system of
standard costing and variances analysis is in operation. The standard material requirement per tonne of
mixed output is 60% material X at 30 per tonne and 40% material at 45 per tonne, with a standard yield
of 90%.
The following information has been gathered for the three months from January to March:
January February March
Output achieved (tones) 810 765 900
Actual material input:
X (in tones) 540 480 700
Y (tones) 360 360 360
Actual material cost (X plus Y) 32,400 31560 38,600
The actual price per tonne oa material Y throughout the January to march period was 45.
Required:-
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Prepare material variance summaries for each of January, February and March which include yield and mix
variance in total plus usage variance for each material and in total.
Q4. A company manufactures chemical ZX by processing chemical Z and chemical X. following are details
related to its proportion of mix and output.
Standard cost of ZX
Kilos
X 45 7 315
Z 15 18 270
60 585
s
Less: Standard losses 06
Standard yield 54
The actual costs are as follows
Material
X
Y
Quantity
Kilos
29,600
7,600
37,200
Price per kg

6.25
18.60
Total

185,000
141,360
326,360
e e
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Less: Actual losses (4,000)
Actual yield 33,200
Required: -
Calculate for each material and in total usage variance, mix and yield variance
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Q5. Carat plc, a premium food manufacturer, is reviewing operations for a three-month period of 2003.
The company operates a standard marginal costing system and manufactures one product, ZP, for which
the following standard revenue and cost data per unit of product is available:
a
Selling price 1200
Direct material A 25 kg at 170 per kg
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Direct material B 15 kg at 120 per kg
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Direct labour 045 hrs at 600 per hour
Fixed production overheads for the three-month period were expected to be 62,500.
Actual data for the three-month period was as follows:
a
Sales and production 48,000 units of ZP were produced and sold for 580,800
Direct material A 121,951 kg were used at a cost of 200,000
Direct material B 67,200 kg were used at a cost of 84,000
Z
Direct labour Employees worked for 18,900 hours, but 19,200 hours were paid at a cost of
117,120
Fixed production overheads 64,000
Budgeted sales for the three-month period were 50,000 units of Product ZP.
Required:
(a) Calculate the following variances:
(i) sales volume contribution and sales price variances;
(ii) price, mix and yield variances for each material;
(iii) labour rate, labour efficiency and idle time variances. (8 marks)
(b) Prepare an operating statement that reconciles budgeted gross profit to actual gross profit
with each variance clearly shown. (5 marks)
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Planning and operational variance
Planning variances are caused by the budget or standard at the planning stage being wrong. The budget
and standard used would therefore need revising if your operational variances are to be more realistic.
Operational variances are your normal variance calculations as learned earlier within this chapter, that is,
assuming all planning errors within the budget have been adjusted for or removed and your standard
used is realistic.
The effect is to sub-divide a variance into 2 parts
1. The planning variance which is beyond the control of staff e.g. planning errors
2. The operational variances which may be within the control of staff
This allows better management information for control purposes
Planning and operational variances are not alternatives to the conventional approach; they just produce a
more detailed analysis. Further analysis of variances into groups e.g. planning which are to do with poor
planning or inadequate standards used compared with actual true favourable or adverse operational
variances, allow managers to be appraised truly on deviations they can control not those variances which
are beyond their control.
Advantages of planning variances
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Highlight between variances which are controllable and uncontrollable
Help motivate managers and staff
Help use more realistic standards
Give a fairer reflection of operational variances
However critism includes still the question of determining a realistic standard in the first place and
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putting too much emphasis on bad planning rather than bad management and the analysis can be
more time consuming and costly than the conventional approach.
Q6. Northcliffe Feeds Ltd manufactures a standard animal feed. The predetermined standards for the
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budget period Jan-March 2005 were set by management in October 2004.
Standard hours per tonne of product 1.1
Standard direct labour rate per hour 8.50
Standard usage of material per tonne of product 1.2 tonnes
Standard price of material 70 per tonne
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Research shows that in the quarter ended 31 March 2005 the prevailing market price of material had been
71 per tonne. Since the budget was set the wage rate had increased to 8.75 per hour, national pay
award.
During the quarter modifications to plant and machinery shows that direct labour hours per unit should
be 1.05 per tonne of product and that standard usage would reduce to 1.175 tonnes per tonne of
product.
During the quarter ended 31 March 2005 activity and costs showed:
Actual production 15,400 tonnes
Raw material usage 16,555 tonnes
Actual cost of raw materials used 1,191,960
Actual direct labour cost 16,632 hours 143,035
Required: -
Calculate direct labour and direct material planning and operational variances.
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Q7. Linsil has produced the following operating statement reconciling budgeted and actual gross profit
for the last three months, based on actual sales of 122,000 units of its single product:
Operating statement
Budgeted gross profit 800,000
Budgeted fixed production overhead 352,000

Budgeted contribution 1,152,000
Sales volume contribution variance 19,200
Sales price variance (61,000)

(41,800)
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Actual sales less standard variable cost of sales 1,110,200
Planning variances
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Variable cost variances Favourable Adverse
Direct material price 23,991
Direct material usage 42,090
Direct labour rate
Direct labour efficiency
Operational variances

42,090
n e 81,333
203,333

303,031 (260,941)

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Variable cost variances Favourable Adverse
Direct material price 31,086
Direct material usage 14,030
Direct labour rate 19,032
a
Direct labour efficiency 130,133

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144,163 50,118 94,045
i

Actual contribution 943,304
Budgeted fixed production overhead (352,000)
a
Fixed production overhead expenditure variance 27,000

Actual fixed production overhead (325,000)
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Actual gross profit 618,304

The standard direct costs and selling price applied during the three-month period and the actual direct
costs and selling price for the period were as follows:
Standard Actual
Selling price (/unit) 3150 3100
Direct material usage (kg/unit) 1300 1280
Direct material price (/kg) 1230 1246
Direct labour efficiency (hrs/unit) 1125 1130
Direct labour rate (/hr) 1200 1260
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After the end of the three-month period and prior to the preparation of the above operating statement, it
was decided to revise the standard costs retrospectively to take account of the following:
1. A 3% increase in the direct material price per kilogram;
2. A labour rate increase of 4%;
3. The standard for labour efficiency had anticipated buying a new machine leading to a 10% decrease in
labour hours; instead of buying a new machine, existing machines had been improved, giving an expected
5% saving in material usage.
Required:
(a) Using the information provided, demonstrate how each planning and operational variance in
the operating statement has been calculated. (11 marks)
(b) Calculate direct labour and direct material variances based on the standard cost data applied
during the three-month period. (4 marks)
(c) Explain the significance of separating variances into planning and operational elements, using
the operating statement above to illustrate your answer. (5 marks)
(d) Discuss the factors to be considered in deciding whether a variance should be investigated.
(5 marks)
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Q8. Crumbly Cakes make cakes, which are sold directly to the public. The new production manager (a
celebrity chef) has argued that the business should use only organic ingredients in its cake production.
Organic ingredients are more expensive but should produce a product with an improved flavour and give
health benefits for the customers. It was hoped that this would stimulate demand and enable an
immediate price increase for the cakes.
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Crumbly Cakes operates a responsibility based standard costing system which allocates variances to
specific individuals. The individual managers are paid a bonus only when net favourable variances are
allocated to them.
The new organic cake production approach was adopted at the start of March 2009, following a decision
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by the new production manager. No change was made at that time to the standard costs card. The
variance reports for February and March are shown below (Fav = Favourable and Adv = Adverse)
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The production manager is upset that he seems to have lost all hope of a bonus under the new system.
The sales manager thinks the new organic cakes are excellent and is very pleased with the progress made.
Crumbly Cakes operate a JIT stock system and holds virtually no inventory.
Required:
(a) Assess the performance of the production manager and the sales manager and indicate whether
the current bonus scheme is fair to those concerned. (7 marks)
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In April 2009 the following data applied:
Standard cost card for one cake (not adjusted for the organic ingredient change)
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The budget for production and sales in April was 50,000 cakes. Actual production and sales was 60,000
cakes in the month, during which the following occurred:
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Required:
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(b) Calculate the material price, mix and yield variances and the sales price and sales contribution
volume variances for April. (13 marks)
Q9. The newly-appointed Managing Director of FX has received the variance report for Month 6, which is
a
shown below:

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Budgeted contribution 90,000
i
Sales volume variance 18,000
Sales price variance 12,000 6,000
96,000
a
Production variances Favourable Adverse
Materials price 6,300
Materials usage 6,000
Z
Labour rate 5,040
Labour efficiency 2,400
Variable overhead expenditure - -
Variable overhead efficiency 1,200
5,040 15,900 10,860
Actual contribution 85,140
Actual fixed production overheads 74,000
Actual profit 11,140
Background information (not seen by the Managing Director)
The report did not include any other information. Details relating to the company and the product that it
makes are given below:
FX produces one type of product. It operates a standard marginal costing system.
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The standard unit cost and price of the product is as follows:

Selling price 250
Direct material (5 kg at 20) 100
Direct labour (4 hours at 10) 40
Variable overheads (4 hours at 5) 20 160
Contribution 90
The variable overhead absorption rate is based on direct labour hours.
The company has budgeted fixed overheads of 70,000 per month.
Budgeted sales and production levels are 1,000 units per month.
The company has just completed Month 6 of its operations. Extracts from its records show:
1. 1,200 units were produced and sold.
2. The actual direct materials purchased and used was 6,300 kg costing 132,300
3. The actual direct labour hours worked were 5,040 hours.
Required:
(a) The Managing Director has recently joined the company and has very little previous financial
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experience. Prepare a report for the Managing Director of FX that explains and interprets the Month 6
variance report. (17 marks)
The Managing Director was concerned about the Material Price variance and its cause. He discovered that
a shortage of materials had caused the market price to rise to 23 per kg.
Required:
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(b) In view of this additional information, calculate for Direct Materials:
The total variance;
The planning variance;
The two operational variances. (7 marks)
(c) Discuss the advantages and disadvantages of reporting planning and operational variances. Your
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answer should refer, where appropriate, to the variances you calculated in (b) above. (6 marks)
Q10. Secure Net (SN) manufacture security cards that restrict access to government owned buildings
around the world. The standard cost for the plastic that goes into making a card is $4 per kg and each
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card uses 40g of plastic after an allowance for waste. In November 100,000 cards were produced and sold
by SN and this was well above the budgeted sales of 60,000 cards.
The actual cost of the plastic was $525 per kg and the production manager (who is responsible for all
buying and production issues) was asked to explain the increase. He said World oil price increases pushed
up plastic prices by 20% compared to our budget and I also decided to use a different supplier who
promised better quality and increased reliability for a slightly higher price. I know we have overspent but
not all the increase in plastic prices is my fault The actual usage of plastic per card was 35g per card and
again the production manager had an explanation. He said
The world-wide standard size for security cards increased by 5% due to a change in the card reader
technology, however, our new supplier provided much better quality of plastic and this helped to cut
down on the waste. SN operates a just in time (JIT) system and hence carries very little inventory.
Required:
(a) Calculate the total material price and total material usage variances ignoring any possible
planning error in the figures. (4 marks)
(b) Analyse the above total variances into component parts for planning and operational variances
in as much detail as the information allows. (8 marks)
(c) Assess the performance of the production manager. (8 marks)
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Practice questions for standard costing and variances
Q11. A local restaurant has been examining the profitability of its set menu. At the beginning of the year
the selling price was based on the following predicted costs:
()
Starter Soup of the day
100 grams of mushrooms at 3.00 per kg 0.30
Cream and other ingredients 0.20
Main course Roast beef
Beef 0.10 kg at 15 per kg 1.50
Potatoes 0.2 kg at 0.25 per kg 0.05
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Vegetables 0.3 kg at 0.90 per kg 0.27
Other ingredients and accompaniments 0.23
Dessert Fresh tropical fruit salad
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Fresh fruit 0.15 kg at 3.00 per kg 0.45
3.00
The selling price was set at 7.50, which produced an overall gross profit of 60%. During October the
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number of set menus sold was 860 instead of the 750 budgeted: this increase was achieved by reducing
the selling price to 7.00. During the same period an analysis of the direct costs incurred showed:
()
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90 kg of mushrooms 300
Cream and other ingredients 160
70 kg of beef 1148
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180 kg of potatoes 40
270 kg of vegetables 250
Other ingredients and accompaniments 200
140 kg of fresh fruit 450
There was no stock of ingredients at the beginning or end of the month.
Requirements:
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(a) Prepare a statement which reconciles budgeted profit and actual profit, showing the variances in as
much detail as possible. (14 marks)
i
(d) Prepare a report, addressed to the restaurant manager, which identifies the two most significant
variances, and comments on their possible causes. (6 marks)
(Total 25 marks)
a
CIMA State 2 Operational Cost Accounting
Z
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Q12. You work as the assistant to the management accountant for a major hotel chain, Stately Hotels plc.
The new manager of one of the largest hotels in the chain, the Regent Hotel, is experimenting with the
use of standard costing to plan and control the costs of preparing and cleaning the hotel bedrooms.
Two of the costs involved in this activity are cleaning labour and the supply of presentation soap packs.
Cleaning labour:
Part-time staff are employed to clean and prepare the bedrooms for customers. The employees are paid
for the number of hours that they work, which fluctuates on a daily basis depending on how many rooms
need to be prepared each day.
The employees are paid a standard hourly rate for weekday work and a higher hourly rate at the weekend.
The standard cost control system is based on an average of these two rates, at 3.60 per hour.
The standard time allowed for cleaning and preparing a bedroom is fifteen minutes.
Presentation soap packs:
A presentation soap pack is left in each room every night. The packs contain soap, bubble bath, shower
gel, hand lotion etc. Most customers use the packs or take them home with them, but many do not. The
standard usage of packs used for planning and control purposes is one pack per room night.
The packs are purchased from a number of different suppliers and the standard price is 1.20 per pack.
Stocks of packs are valued in the accounts at standard price.
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Actual results for May:
During May 8400 rooms were cleaned and prepared. The following data were recorded for cleaning
labour and soap packs.
Cleaning labour paid for:
Weekday labour 1850 hours at 3 per hour
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Weekend labour 700 hours at 4.50 per hour
Presentation soap packs purchased and used:

6530 packs at 1.20 each
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8580
Required:
(a) Using the data above, calculate the following cost variances for May:
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(i) soap pack price;
(ii) soap pack usage;
(iii) cleaning labour rate;
(iv) cleaning labour utilization or efficiency.
(b) Suggest one possible cause for each of the variances which you have calculated, and outline any
management action which may be necessary.
AAT Technicians Stage
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Q13. Nihal Limited manufactures a single product and uses a standard costing system. Due to a technical
fault, some of the accounting data has been lost and it will take sometime before the issue is resolved.
The management needs certain information urgently. It has been able to collect the following data from
the available records, relating to the year ended March 31, 2008:
(i) The following variances have been ascertained:
Rs.
Adverse selling price variance 24,250,000
Favourable sales volume variance 2,000,000
Adverse material price variance X 2,295,000
Favourable material price variance Y 2,703,000
Favourable material price variance Z 3,799,500
s
The overall material yield variance is nil but consumption of X is 10% below the budgeted quantity
whereas consumption of Y is 6% in excess of the budgeted quantity
(ii) The budgeted sale price of Rs. 100 was 5.26% higher than actual sale price.
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(iii) The standard cost data per unit of finished product is as follows:
No. of kgs Standard price Standard Cost / unit
X 5 3.00 15.00
Y
Z
10
15
2.00
1.80
(iv) During the year, actual production was 230,000 units
Required:
(a) Total actual cost of each raw material consumed
(b) Material mix variance.
n e 20.00
27.00
(6 marks)
(12 marks)
A
ICAP Module F Management Accounting
(Mix variance: 110,400 fav), (actual cost of material X = 5,399,595, material Y = 2,173,000, material Z =
2,369,100)
a
Q14. Wahid Limited established a plant to manufacture a single product ARIDE. Standard material costs
for the first year of operations were as under:
r
Raw material Standard price
i
A 6.40 per kg
B 4.85 per kg
C 5.90 per kg
a
All the raw materials were supplied at same prices throughout the first six months. Thereafter the prices
were increased by 10%. The company manufactured 1,320,000 units during the year ended 30 September,
2009. All purchases and the production were made evenly throughout the year.
Z
Losses occurred at an even rate during the processing and are estimated at 12% of the input quantity. The
standard weight of one unit of finished product is 11.88 kgs. The ratio of input quantities of materials A, B
and C is 3:2:1 respectively. Details of ending inventory are as under:
Required:
Calculate material mix and yield variances. (12 marks)
(Mix variance = 307,000 fav, yield variance = 290,000 adv)
Page 15 of 106
Q15. Chaman Corporation manufactures a single product ANJ. During the month of November 2007, it
sold 5,120 kgs of the product @ Rs. 40 per kg. 150 batches of the product were manufactured during the
month. The costs incurred during the month are as follows:
Materials Kg Price per Kg Total
Rs. Rs.
A 2,400 7.70 18,480
B 2,000 25.60 51,200
C 1,150 62.40 71,760
5,550 141,440
Standard costs per batch as determined by the Technical Department are given below:
Materials Kg Price per Kg (Rs.) Total (Rs.)
A 17.0 6 102
B 11.5 26 299
C 8.5 60 510
37 911
Less: Standard loss 1
Standard yield 36
S
There was no opening or closing stocks.
Required:
(a) Calculate the following material variances:
i. price variance ii. mix variance iii. yield variance
M
Q16. Sarhad Industries Limited is a manufacturing company which produces a single product. It operates
a standard costing system and the management accountant had calculated the following variances:
Rupees Rupees
A
Materials Labour
Usage 4,200 (F) Efficiency 10,780 (A)
Price 9,520 (A) Rate 4,200 (F)
Variable overhead Fixed overhead
Total 540 (A) Volume 8,220 (F)
C
Expenditure 2,620 (A)
The following additional information is available:
1. Price paid for raw material was Re. 0.40 per kg more than the standard price.
2. Closing stock of raw material was 200 kgs more than the opening stock.
3. Actual wage rate paid during the month was Rs. 3.40 per hour.
4. All overheads are absorbed on the basis of standard hours produced using the following rates:
Fixed overheads Rs. 5.00 per standard hour
Variable overheads Rs. 0.50 per standard hour
6. The following actual costs for December 2005 have been incurred:
Rupees
Materials used 199,920
Wages incurred 142,800
Variable overheads 20,000
Fixed overheads 189,000
7. Actual production of finished goods during December 2005 was 4,865 units.
Required:
Prepare a standard cost sheet. ICAP Module F Management Accounting
Page 16 of 106
Advanced: Planning and operating variances plus mix and yield variances
Q17. County Preserves produce jams, marmalade and preserves. All products are produced in a similar
fashion; the fruits are low temperature cooked in a vacuum process and then blended with glucose syrup
with added citric acid and pectin to help setting. Margins are tight and the firm operates a system of
standard costing for each batch of jam.
The standard cost data for a batch of raspberry jam are:
Fruit extract 400 kg at 0.16 per kg
Glucose syrup 700 kg at 0.10 per kg
Pectin 99 kg at 0.332 per kg
Citric acid 1 kg at 2.00 per kg
Labour 18 hrs at 3.25 per hour
s
Standard processing loss 3%.
The summer proved disastrous for the raspberry crop with a late frost and cool, cloudy conditions at the
ripening period, resulting in a low national yield. As a consequence, normal prices in the trade were 0.19
e
per kg for fruit extract although good buying could achieve some savings. The impact of exchange rates
on imports of sugar has caused the price of syrup to increase by 20%.
The actual results for the batch were:
Fruit extract
Glucose syrup
Pectin
Citric acid
Labour
428 kg at 0.18 per kg
1 kg at 0.95 per kg
20 hrs at 3.00 per hour
Actual output was 1164 kg of raspberry jam.
n e
A
You are required to
(a) calculate the ingredients planning variances that are deemed uncontrollable; (4 marks)
(b) calculate the ingredients operating variances that are deemed controllable; (4 marks)
(c) comment on the advantages and disadvantages of variance analysis using planning and operating
a
variances; (4 marks)
(d) calculate the mixture and yield variances; (5 marks)
r
(e) calculate the total variance for the batch. (3 marks)
i
(Total 20 marks)
CIMA Stage 3 Management Accounting Techniques
Hint: Since usage variance is based on revised standard price therefore for the calculation of its sub
a
variances, revised prices will be used
Mix variance = 3.40 adv
Yield variance = 15.59 adv
Z
Page 17 of 106
What is a standard cost?
A standard cost is a planned or forecast unit cost for a product or service, which is assumed to hold good
given expected efficiency and cost levels within an organisation. It represents a target cost and is useful
for planning, controlling and motivating within an organisation.
Standard costing system most suited to an organization whose activities consists of a series of common or
repetitive operations and the input required to produce each unit of output is specified
Standard costing can be used for

Budget preparation e.g. planning
Control through exception reporting e.g. performance measurement
Provide challenging targets to achieve motivation among employees
Performance evaluation
Stock valuation
Cost bookkeeping.
Motivating staff
S
Critism of standard costing
Sometimes hard to define an attainable standard
Uncontrollability of performance within operations e.g. discounts lost due to the reduction in the
quantity ordered or seasonal price fluctuations within the period of appraisal
With more automation within operations, they become less valuable as information
M
Feedback not feed forward control e.g. out of date information
Revisions to standards may be too frequent to guide performance over time
Standard costing is an internal not external control measure e.g. improvement also needs to consider
competition and customers
A
Performance measurement would be inadequate as a process if the standard is wrong
The reason or cause of the variance are sometimes overlooked or not investigated
Types of standard
C
There are four types of standard cost, as follows.
Ideal standard
This is a standard that reflects perfect performance and is the minimum cost that is possible under ideal
operating conditions. Because ideal standards are unattainable, they are unlikely to be used in practice,
since inability to achieve them is likely to have a demotivating effect on managers and employees.
Basic standard
This is a standard that remains unchanged for long periods of time. Because it remains unchanged, it
allows efficiency trends over time to be identified. Because basic standards do not reflect current
conditions, they are of limited use if current conditions differ significantly from those existing when the
standard was set. They are therefore seldom used.
Attainable standard
This standard allows for normal levels of wastage and operation, and represents a cost level achievable
under reasonably efficient working. Attainable standards may be difficult to achieve, but they do not
represent impossible targets for employees.
An attainable standard is considered to represent the best target against which to compare current
activity and is the preferred standard to use in planning, budgeting and cost control.
Page 18 of 106
Current standard
This standard is one established for use over a short period of time and relates to current conditions.
How to set standard

Standard material price
Supplier quotations and estimates
Previous invoices/trends
Internet/websites of suppliers
Discounts for bulk purchases
s
Price seasonality
Cost to manufacture internally
Differences between the quality of different material
Standard material usage
Time/motion studies
Quality of material e.g. natural wastage
Specification of standard product manufactured
Operational wastage expected
e e
n
Standard labour rate
Market rate for grade/type of labour
Internal rates from HR department
A
Bonus schemes/piece work rates in current use
Standard labour efficiency
Idle time expected during operations
Time/motion studies
a
Skill/expertise of staff
Learning curve
r
Motivation of staff
i
Remuneration systems in place
Standard overhead rate
a
Overhead absorption rates obtained by dividing forecast overhead with an expected level of activity
Review overhead
Understand fixed and variable relationship with output, labour hours, machine hours or % of cost
Z Factors to consider before investigation

1. The size of it (materiality)
2. The general trend of it e.g. use of control charts for this
3. The type of standard that was used
4. Interdependence with other variances
5. The likelihood of identifying the cause of it
6. The likelihood that if a cause is found then it is controllable
7. The cost and benefits of correcting the cause
8. The cost of the investigation
Page 19 of 106
Causes of variances
Material price variance
Change of material supplier.
Unexpected change in general price.
Alteration in quantity discounts or unforeseen discount
Alteration in exchange rates (imported goods)
Substitution of a different grade of material
Standard set at mid-year price so one would expect a favourable price variance for part of the year and
an adverse variance for the rest of the year.
Material usage variance
Higher/lower incidence of scrap.
Alteration to product design.
Substitution of a different grade of material.
Lack of machine maintenance
Use of unskilled labour
S
Wage rate variance
Unexpected national wage award.
Overtime/bonus payments different from plan.
Substitution of a different grade of labour
Demand and Supply of labour
M
Labour efficiency variance
Improvement in methods or working conditions.
Variations in unavoidable idle time.
Introduction of incentive scheme.
A
Substitution of a different grade of labour.
Low quality material
Variable overhead variance
Unexpected price changes for overhead items.
C
Labour efficiency variances
Fixed overhead expenditure variance
Changes in prices relating to fixed overhead items e.g. rent increase.
Seasonal effects e.g. heat/light in winter.
Fixed overhead volume variance
Change in production volume due to change in demand or alterations to stockholding policy.
Changes in productivity of labour or machinery.
Production lost through strikes etc.
Sales price variance
Change in demand or supply of product
Different quality of product due to
- Low quality material
- Mix or yield variance
- Use of inefficient labour
To increase or achieve a targeted sales volume or market share
Increase or decrease in competition level
Page 20 of 106
Sales volume variance
Change in price of the product
Different quality of product due to
Reduction in market share
Reduction in overall market size
Due to discontinuation of complementary product
Material mix variance
Favourable mix variance incur if company uses high proportion of cheap quality material and vice
versa
To improve performance of production department or to get any personal benefit like bonus
s
To implement cost cutting exercise in a competitive environment
Unavailability of any material
Material yield variance
e
Favourable yield variance incur if company manufacture more output with less standard input
Change in actual losses as compared with expected
Use of different labour (unskilled labour normally produces adv yield variance vice versa)

Use of different quality of material
Lack of machine maintenance
Market share variance

Due to different advertisement policies.
Quality of the product
n e
A
Customer satisfaction and retention level (usually low satisfaction level yields low customer retention).
Competition level
Price of the product
Market share variance is controllable by company and considered by operational variance
Market size variance

r a
Due to recession in any inter-related industry
Due to development of any substitute product
i
Economic recession.
High inflation or interest rates
Market size variance is uncontrollable by company and considered as planning variance.
Z a
Please read examiner article on MATERIAL MIX AND YIELD VARIANCE and PLANNING AND
OPERATIONAL VARIANCE from ACCA website by using following link
http://www.accaglobal.com/students/acca/paperf5/syllabus_d
End of Section D
Page 21 of 106
Section A
Activity Based Costing (ABC)
Q1. A company manufactures two products Alpha and Beta. A detailed evaluation of the incremental fixed
costs for the first year of producing Alpha and Beta reveals the following information on the composition
of the fixed costs and their associated cost drivers.
Fixed cost Cost driver Alpha Beta Total
Power, heating, etc. 505,000 Floor area 3,500 m2 6,500 m2 10,000 m2
Salaries 300,000 Labour hours 10,000 15,000 25,000
Inspection costs 135,000 Inspections 3,000 3,750 6,750
Maintenance 26,000 Maintenance hours 625 1,875 2,500
Set-up costs 34,000 Set-ups 120 50 170
i) Calculate activity-based recovery rates for each fixed cost
ii) Calculate the overhead cost per unit for each product using an activity-based approach.
iii) Following are other data given about Alpha and Beta
S
Product Alpha Beta
/unit /unit
Prime cost 25.00 32.00
Profit mark up 20% 25%
Calculate cost per unit and selling price of each product by using results of (ii)
M
Q2. Triple Limited makes three types of gold watch the Diva (D), the Classic (C) and the Poser (P). A
traditional product costing system is used at present; although an activity based costing (ABC) system is
being considered. Details of the three products for a typical period are:
Hours per unit Material Production
A
Labour hours Machine hours Cost per unit ($) Units
Product D 1 20 1 ,750
Product C 1 1 12 1,250
Product P 1 3 25 7,000
C
Direct labour costs $6 per hour and production overheads are absorbed on a machine hour basis. The
overhead absorption rate for the period is $28 per machine hour.
Required:
(a) Calculate the cost per unit for each product using traditional methods, absorbing overheads on the
basis of machine hours.
Total production overheads are $654,500 and further analysis shows that the total production overheads
can be divided as follows:
%
Costs relating to set-ups 35
Costs relating to machinery 20
Costs relating to materials handling 15
Costs relating to inspection 30
Total production overhead 100
Page 22 of 106
The following total activity volumes are associated with each product line for the period as a whole:
Number of Number of movements Number of
Set ups of materials inspections
Product D 175 112 1,150
Product C 115 121 1,180
Product P 480 187 1,670
670 120 1,000
Required:
(a) Calculate activity based recovery rates (4 marks)
(b) Calculate the cost per unit for each product using ABC principles (work to two decimal places).
(C) Discuss why absorption costing gives better result as compared with traditional absorption costing in
s
todays manufacturing environment. (4 marks)
Comment
e
The overhead costs per unit are summarised below together with volume of production.
Product D C P
Volume 750 1,250 7,000
Conventional overheads
ABC overheads
$42
$95
n e
$28
$79
$84
$69
The result of the change to Activity Based Costing is clear, the overhead cost of D and C have risen whilst
that of P has fallen.
This is in line with the comments of many who feel that ABC provides a fairer unit cost better reflecting
the effort required to make different products. This is illustrated here with product P which may take
A
longer to make than D or C, but once production has started the process is simple to administer. This may
be due to having much longer production lines.
Products D and C are relatively minor volume products but still require a fair amount of administrative
time by the production department; ie they involve a fair amount of `hassle`. This is explained by the
a
following table of `activities per 1,000 units produced`.
r
Set-ups Materials movements Inspections
i
D 100 16 200
C 92 17 144
P 69 12 96
a
This table highlights the problem.
Product P has fewer set-ups, material movements and inspections per 1,000 units than or C
As a consequence product Ps overhead cost per unit for these three elements has fallen
Z
The machining overhead cost per unit for P is still two or three times greater than for products D or C,
but because this overhead only accounts for 20% of the total overhead this has a small effect on total
cost.
The overall result is Ps fall in production overhead cost per unit and the rise in those figures for D and C
(d) Pricing and Profitability

Switching to ABC can, as in this case, substantially change the costs per unit calculations. Consequently if
an organisations selling prices are determined by a version of cost-plus pricing then the selling prices
would alter.
In this case the selling price of D and C would rise significantly, and the selling price of P would fall. This,
at first glance may be appealing however:
Page 23 of 106
Will the markets for D and C tolerate a price rise? There could be competition to consider. Will
customers be willing to pay more for a product simply because Triple Ltd has changed its cost allocation
methods?
Product P is a high volume product. Reducing its selling price will have a dramatic effect on revenue and
contribution.
One would have to question whether such a reduction would be compensated for by increased volumes.
Alternatively, one could take the view that prices are determined by the market and therefore if Triple Ltd
switches to ABC, it is not the price that would change but the profit or margin per unit that would change.
This can change attitudes within the business. Previously high margin products (under a traditional
overhead absorption system) would be shown as less profitable. Salesmen (possibly profit motivated) can
begin to push the sales of different products seeking higher personal rewards. (Assuming commission
based on profits per unit sold) It must always be remembered that if overheads are essentially fixed then
they should be ignored in business decision making.
Switching to ABC can change reported profits per unit but it is contribution per unit that is perhaps more
important.
Q3. Linacre Co operates an activity-based costing system and has forecast the following information for
S
next year.
Cost Pool Cost Cost Driver No of Drivers
Production set-ups 105,000 Set-ups 300
Product testing 300,000 Tests 1,500
Component supply and storage 25,000 Component orders 500
M
Customer orders and delivery 112,500 Customer orders 1,000
General fixed overheads such as lighting and heating, which cannot be linked to any specific activity, are
expected to be 900,000 and these overheads are absorbed on a direct labour hour basis. Total direct
labour hours for next year are expected to be 300,000 hours.
A
Linacre Co expects orders for Product ZT3 next year to be 100 orders of 60 units per order and 60 orders
of 50 units per order. The company holds no stocks of Product ZT3 and will need to produce the order
requirement in production runs of 900 units. One order for components is placed prior to each production
run. Four tests are made during each production run to ensure that quality standards are maintained. The
following additional cost and profit information relates to product ZT3:
C
Component cost: 100 per unit
Direct labour: 10 minutes per unit at 780 per hour
Profit mark up: 40% of total unit cost
Required:
(a) Calculate the activity-based recovery rates for each cost pool.
Q4. Jola Publishing Co publishes two forms of book.

The company publishes a childrens book (CB), which is sold in large quantities to government controlled
schools. The book is produced in only four large production runs but goes through frequent government
inspections and quality assurance checks. The paper used is strong, designed to resist the damage that
can be caused by the young children it is produced for.
The book has only a few words and relies on pictures to convey meaning.
The second book is a comprehensive technical journal (TJ). It is produced in monthly production runs, 12
times a year. The paper used is of relatively poor quality and is not subject to any governmental controls
and consequently only a small number of inspections are carried out. The TJ uses far more machine hours
than the CB in its production.
Page 24 of 106
The directors are concerned about the performance of the two books and are wondering what the impact
would be of a switch to an activity based costing (ABC) approach to accounting for overheads. They
currently use absorption costing, based on machine hours for all overhead calculations. They have
accurately produced an analysis for the accounting year just completed as follows:
CB TJ
$per unit $per unit $per unit $per unit
Direct production costs
Paper 075 008
Printing ink 145 447
Machine costs 115 195
335 650
s
Overheads 230 395
Total cost 565 1045
Selling price 905 1385
e
Margin 340 340
The main overheads involved are:
Overhead % of total overhead Activity driver
Property costs
Quality control
750%
230%
Production set up costs 20%
Machine hours
e
Number of inspections
n
Number of set ups
If the overheads above were re-allocated under ABC principles then the results would be that the
overhead allocation to CB would be $005 higher and the overhead allocated to TJ would be $030 lower
than previously.
A
Required:
(a) Explain why the overhead allocations have changed in the way indicated above.
(b) Briefly explain the implementation problems often experienced when ABC is first introduced.
The directors are keen to introduce ABC for the coming year and have provided the following cost and
selling price data:
r a
1. The paper used costs $2 per kg for a CB but the TJ paper costs only $1 per kg. The CB uses 400g of
paper for each book, four times as much as the TJ uses.
i
2. Printing ink costs $30 per litre. The CB uses one third of the printing ink of the larger TJ. The TJ uses
150ml of printing ink per book.
3. The CB needs six minutes of machine time to produce each book, whereas the TJ needs 10 minutes per
a
book. The machines cost $12 per hour to run.
4. The sales prices are to be $930 for the CB and $1400 for the TJ As mentioned above there are three
main overheads, the data for these are:
Z
Overhead Annual cost for the coming year
$
Property costs 2,160,000
Quality control 668,000
Production set up costs 52,000
Total 2,880,000
The CB will be inspected on 180 occasions next year, whereas the TJ will be inspected just 20 times. Jola
Publishing will produce its annual output of 1,000,000 CBs in four production runs and approximately
10,000 TJs per month in each of 12 production runs.
Page 25 of 106
Required:
(c) Calculate the cost per unit and the margin for the CB and the TJ using machine hours to absorb
the overheads.
(d) Calculate the cost per unit and the margin for the CB and the TJ using activity based costing
principles to absorb the overheads.
The first thing to point out is that the overhead allocations to the two products have not changed by that
much. For example the CB has absorbed only $005 more overhead. The reason for such a small change is
that the overheads are dominated by property costs (75% of total overhead) and the driver for these
remains machine hours once the switch to ABC is made.
Thus no difference will result from the switch to ABC in this regard.
The major effect on the cost will be for quality control. It is a major overhead (23% of total) and there is a
big difference between the relative number of machine hours for each product and the number of
inspections made (the ABC driver). The CB takes less time to produce than the TJ, due to the shortness of
the book. It will therefore carry a smaller amount of overhead in this regard. However, given the high
degree of government regulation, the CB is subject to frequent inspections whereas the TJ is inspected
S
only rarely. This will mean that under ABC the CB will carry a high proportion of the quality control cost
and hence change the relative cost allocations.
The production set up costs are only a small proportion of total cost and would be, therefore, unlikely to
cause much of a difference in the cost allocations between the two products. However this hides the very
M
big difference in treatment. The CB is produced in four long production runs, whereas the TJ is produced
monthly in 12 production runs. The relative proportions of overhead allocated under the two overhead
treatments will be very different. In this case the TJ would carry much more overhead under ABC than
under a machine hours basis of overhead absorption.
A
(b) There are many problems with ABC, which, despite its academic superiority, cause issues on its
introduction.
Lack of understanding. ABC is not fully understood by many managers and therefore is not fully
accepted as a means of cost control.
C
Difficulty in identifying cost drivers. In a practical context, there are frequently difficulties in identifying
the appropriate drivers. For example, property costs are often significant and yet a single driver is difficult
to find.
Lack of appropriate accounting records. ABC needs a new set of accounting records, this is often not
immediately available and therefore resistance to change is common. The setting up of new cost pools is
needed which time is consuming.
Q5. An analysis of the companys indirect production costs shows the following:
Page 26 of 106
$ Cost driver
Machine setup costs 120,600 Number of batches
Material ordering costs 64,800 Number of supplier orders
General facility costs 337,500 Number of machine hours
The following additional data relate to each product:
Product W X Y
Prime cost 15 24 35
Machine hours per unit 5 8 7
Batch size (units) 500 400 1,000
Supplier orders per batch 4 3 5
Demand 8,000 6,000 5,000
s
Required:
(a) Calculate the full cost per unit of each product using Activity Based Costing. (8 marks)
(b) Explain how Activity Based Costing could provide information that would be relevant to the
e
management team when it is making decisions about how to improve KLs profitability. (4 marks)
Q6. Naceur makes three products A, B and C. Budgeted cost and production information for the coming
period is as follows:
Product
Costs
Direct materials
Direct labour
A
12000
4200
B
Per thousand metres
10000
4200
C
n e
6000
2800
A
Machine hours 600 hrs 600 hrs 400 hrs
Labour hours 01 hrs 01 hrs 002 hrs
Output in thousand metres 120 100 80
The three products are manufactured using the same production technology. They are usually produced
a
in production runs of 10,000 metres and sold to wholesalers in batches of 5,000 metres. The company
uses a cost plus pricing system and a gross margin of 20% on sales to calculate prices. Budgeted
r
production overhead is absorbed using a machine hour rate and the budgeted overhead for the coming
i
period has been analysed as follows:

Rates, rent, supervision, power and depreciation 26,000
a
Set up costs 15,000
Goods inwards 9,600
Finished goods inspection 5,250
Z
Dispatch 9,750
Total 65,600
Budgeted machine hours for the period are 1,640 hours.
Required:
(a) (i) Calculate the budgeted total cost per thousand metres for each product, showing clearly
prime cost, overhead cost and total cost; (5 marks)
(ii) Using your total cost estimates from (a) (i) and a GROSS MARGIN of 20% on sales calculate the
budgeted price per thousand metres of each of the three products. (3 marks)
(b) The sales manager of Naceur has complained that its main competitor is undercutting its prices for
products A and B by several pounds. Naceurs price for product C on the other hand is lower than that of
the competitor. She believes these price differences are caused by their competitor using an activity-
based costing (ABC) system to cost products, and a cost plus pricing system with a mark-up of 20% on
Page 27 of 106
total activity based cost to calculate prices. In an attempt to make Naceurs costings more accurately
reflect the usage of resources by products you have ascertained that the cost drivers for the overhead
activities are as follows:
Cost Pool Cost driver Budgeted driver
activity for the period
Rates, rent supervision,

power and depreciation machine hours 1,640
Set up costs number of production runs 30
Goods inwards costs Number of requisitions 120
Finished goods inspection costs number of production runs 30
Dispatch costs Number of sales orders 60
The number of requisitions raised by goods inwards was 40 for each product and the number of sales
orders was 60 (one order per batch sold).
Required:
(i) Calculate the budgeted cost driver rate for each overhead activity; (5 marks)
(ii) Calculate the budgeted total cost per thousand metres for each product using an activity-based
S
costing approach; (10 marks)
Answer : Total overhead cost: 22177 22710 20340
Q7. F Company supplies pharmaceutical drugs to drug stores. Although the company makes a satisfactory
return, the directors are concerned that some orders are profitable and others are not. The management
M
has decided to investigate a new budgeting system using activitybased costing principles to ensure that
all orders they accept are making a profit.
Each customer order is charged as follows. Customers are charged the list price of the drugs ordered plus
an additional charge for overheads. A profit margin is also added, but that does not form part of this
A
analysis and can therefore be ignored.
Currently F Company uses a simple absorption rate to absorb these overheads. The rate is calculated
based on the budgeted annual overhead costs divided by the budgeted annual total list price of the drugs
C
ordered.
An analysis of customers has revealed that many customers place frequent small orders with each order
requesting a variety of drugs. The management of F Company has examined more carefully the nature of
its overhead costs, and the following data have been prepared for the budget for next year:
Total list price of drugs supplied $8m
Number of customer orders 8,000
Overhead costs $000 Cost driver
Invoice processing 280 See Note 2
Packing 220 Size of package see Note 3
Delivery 180 Number of deliveries see Note 4
Other overheads 200 Number of orders
Total overheads 880
Notes:
Page 28 of 106
1. Each order will be shipped in one package and will result in one delivery to the customer and one
invoice (an order never results in more than one delivery).
2. Each invoice has a different line for each drug ordered. There are 28,000 invoice lines each year. It is
estimated that 25% of invoice processing costs are related to the number of invoices, and 75% are related
to the number of invoice lines.
3. Packing costs are $32 for a large package, and $25 for a small package.
4. The delivery vehicles are always filled to capacity for each journey. The delivery vehicles can carry either
6 large packages or 12 small packages (or appropriate combinations of large and small packages). It is
estimated that there will be 1,000 delivery journeys each year, and the total delivery mileage that is
specific to particular customers is estimated at 350,000 miles each year. $40,000 of delivery costs are
related to loading the delivery vehicles and the remainder of these costs are related to specific delivery
s
distance to customers.
The management has asked for two typical orders to be costed using next years budget data, using the
current method, and the proposed activity-based costing approach.
Details of two typical orders are shown below:
Lines on invoice
Package size
Order A
2
Small
Order B
8
Large
e e
n
Specific delivery distance 8 miles 40 miles
List price of drugs supplied $1,200 $900
Required:
(a) Calculate the charge for overheads for Order A and Order B using:
A
(i) the current system; and (3 marks)
(ii) the activity-based costing approach. (12 marks)
(b) Write a report to the management of F Company in which you assess the strengths and weaknesses of
the proposed activity-based costing approach for F company; (5 marks)
a
(Total: 20 marks)
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Reasons why activity-based costing may be preferred to traditional
absorption
Traditional absorption costing allocates a proportion of fixed overheads (indirect costs) to product cost
through an overhead absorption rate, usually based on labour hours, machine hours, or some other
volume-related measure of activity. These overhead absorption rates may be factory-wide absorption
rates (blanket rates) or, for increased accuracy in determining product cost, departmental absorption
rates. In the traditional manufacturing environment, indirect costs constituted a relatively small proportion
of total product cost compared to direct costs such as direct material cost, direct labour cost and direct
expenses (collectively referred to as prime cost).
i) The modern manufacturing environment
e s
In the modern manufacturing environment, indirect costs constitute a relatively high proportion of total
product cost. There are several reasons for this. Modern manufacturing is characterised by shorter and
more frequent production runs rather than continuous or high volume production runs. This increases the
frequency of production line set-ups and therefore the total cost arising from set-up activity.
ii) Activities and costs
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Traditional absorption costing, by employing volume-related overhead absorption rates, failed to take
account of the relationship between costs, activities and products. The insight at the heart of activity-
based costing is that it is activities that incur costs and products that consume activities. Analysis of the
way in which products consume activities allows the overhead costs incurred by those activities to be
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related to product cost using cost drivers derived from those activities rather than using production
volume-related overhead absorption rates.
For example, set-up costs under traditional absorption costing could have been allocated to product cost
using an overhead absorption rate based on machine hours. This would transfer a disproportionate
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amount of set-up costs to high volume products, which in fact gave rise to fewer set-ups because of their
longer production runs. If set-up costs were transferred using number of set-ups as the cost driver, a
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fairer allocation of set-up costs would be achieved and products with longer production runs would not
be penalised with a disproportionate share of their indirect costs.
iii) Improved cost control
a
Activity-based costing can lead to more detailed product cost information because a larger number of
ABC cost drivers are likely to be identified in a given manufacturing organisation. An average of fifteen
ABC cost drivers tends to be used, compared with one or two overhead absorption rates in traditional
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absorption costing. This more detailed product cost information can lead to improved cost control, since
managers can seek to control costs by controlling the activities that cause the costs to be incurred.
Production scheduling, for example, can optimise the number of production runs in order to minimise set-
up costs.
iv) Better information on product profitability

Since product cost information is more accurate, managers have more accurate information on the
relative profitability of individual products. This can lead to better decisions on product promotion and
pricing, since managers can promote higher margin products while seeking to improve margins on
products where margins are lower.
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ABC has a number of advantages:
It provides much better insight into what drives overhead costs.
ABC recognizes that overhead costs are not all related to production and sales volume.
In many businesses, overhead costs are a significant proportion of total costs, and management
needs to understand the drivers of overhead costs in order to manage the business properly.
Overhead costs can be controlled by managing cost drivers.
It can be applied to derive realistic costs in a complex business environment.
ABC can be applied to all overhead costs, not just production overheads.
ABC can be used just as easily in service costing as in product costing.
Criticisms of ABC:
It is impossible to allocate all overhead costs to specific activities.
ABC costs are based on assumptions and simplifications. The choice of both activities and cost drivers
might be inappropriate.
ABC can be more complex to explain to the stakeholders of the costing exercise.
The benefits obtained from ABC might not justify the costs.
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The implications of switching to ABC
The use of ABC has potentially significant commercial implications:
Pricing can be based on more realistic cost data.
The traditional method of absorption of overheads into unit costs on a volume basis may be
misleading, with the result that product costs can, potentially, be materially under/over stated.
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Thus, where cost plus pricing is in use, products that have been materially under-costed may be
priced at levels that generate a loss whilst products that have been materially over-costed may be
priced at levels that are uncompetitive.
Sales strategy can be more soundly based.
A
More realistic product costs as a result of the use of ABC may enable sales staff to:
Target customers that appeared unprofitable using absorption costing but may be profitable
under ABC
Stop targeting customers or market segments that are now shown to offer low or negative
sales margins.
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Front line sales staff will be able to negotiate prices with greater confidence
ABC can be used to review the profitability of products and services with a view to focusing the
efforts of sales staff upon those products and services which offer the highest sales margins.
Performance management and decision making can be improved
Research, production and sales effort can be directed towards those products and services which
ABC has identified as offering the highest sales margins
ABC can influence decisions as to which:
New products/services to develop
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Target costing
Target costing involves setting a target cost by subtracting a desired profit margin from a competitive
market price. A target cost may be less than the planned initial cost but it is expected to be achieved by
the time a product reaches its maturity stage of the product lifecycle.
Target costing was introduced by major Japanese manufactures for use in a manufacturing environment
where:
A new product was to be designed to meet the target cost
A substantial part of the production cost consisted of bought-in materials
s
This environment facilitates use of a target cost approach since:
Professional design teams can alter the design specification of a new product until it matches their
cost requirements.
e
Service industries (e.g.) banking, insurance, travel) provide a less favourable environment for the use of
target costing:
It is much more difficult to make service comparisons than product comparisons, making it harder to
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determine a market driven price in the first place.
The introduction of new products and services in service industries usually occurs far less frequently
than in a manufacturing environment (e.g. Sony and Toyota introduce new models on a regular basis)
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and, in consequence, the equivalent of manufacturing design teams are rarely found in service
industries.
Bought in materials are usually of modest significance so there is little scope for exerting pressure on
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external suppliers.
The major cost of any new product or service is salaries and unless lower cost delivery mechanisms
(e.g. the internet) or radically different ways of working can be exploited there is limited scope for
substantial cost reduction.
a
The implications of using target costing on pricing, cost control and performance management
Pricing
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Target costing forces product/service designers to think outside the box and identify new and
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imaginative ways in which costs can be reduced in order to meet the target cost.
This approach can result in substantial cost savings being identified, thereby enabling prices to be set
at levels that are very competitive but still generate a profit. A policy of penetration pricing can then
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be pursued with a view to substantial market share being captured.
Target costing is usually is usually considered superior to cost plus pricing as it considers the demand
for a product or service. As long as the estimates for demand at the target price are accurate and
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costs are controlled then an organization will achieve its required return on investment.
Cost control and performance management
Target costing has a potentially major positive impact on cost control since it seeks to change the
accounting mindset from one of recording costs to one of reducing costs in recording that the cost
target can be met.
The requirement to meet a target cost can generate new ideas and new ways of working which in turn
can generate substantial cost savings and facilitate a more proactive approach to cost control.
Performance management is also potentially enhance since the setting of a target cost requires a
business to identify how costs can be managed down to the target cost level. This may involve
product/service redesign and new ways of working (e.g. outsourcing, greater use of the internet etc.)
Closing the target cost gap
Target cost gap = Estimated product cost Target cost
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It is the difference between what an organization thinks it can currently make a product for, and what
needs to make it for, in order, in order to make a required profit.
Factors which a manufacturer should consider in order to close the gap include:
Can any materials can be eliminated, e.g. cut down on packing materials?
Can a cheaper material be substituted without affecting quality?
Can labour savings be made, for example, by using lower skilled workers?
Can productivity be improved, for example, by improving motivation?
What production volume is needed to achieve economies of scale?
Could cost savings be made by reviewing the supply chain?
Can the incidence of the cost drivers be reduced?
Is there some degree of overlap between the product-related fixed costs that could be eliminated by
combining service departments or resources?
Q1. Edward Co assembles and sells many types of radio. It is considering extending its product range to
include digital radios. These radios produce a better sound quality than traditional radios and have a large
number of potential additional features not possible with the previous technologies (station scanning,
more choice, one touch tuning, station identification text and song identification text etc).
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A radio is produced by assembly workers assembling a variety of components. Production overheads are
currently absorbed into product costs on an assembly labour hour basis.
Edward Co is considering a target costing approach for its new digital radio product.
Required:
(a) Briefly describe the target costing process that Edward Co should undertake. (3 marks)
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(b) Explain the benefits to Edward Co of adopting a target costing approach at such an early stage
in the product development process. (4 marks)
(c) Assuming a cost gap was identified in the process, outline possible steps Edward Co could take
to reduce this gap. (5 marks)
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A selling price of $44 has been set in order to compete with a similar radio on the market that has
comparable features to Edward Cos intended product. The board have agreed that the acceptable margin
(after allowing for all production costs) should be 20%.
Cost information for the new radio is as follows:
Component 1 (Circuit board) these are bought in and cost $410 each. They are bought in batches of
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4,000 and additional delivery costs are $2,400 per batch.
Component 2 (Wiring) in an ideal situation 25 cm of wiring is needed for each completed radio.
However, there is some waste involved in the process as wire is occasionally cut to the wrong length or is
damaged in the assembly process. Edward Co estimates that 2% of the purchased wire is lost in the
assembly process. Wire costs $050 per metre to buy.
Other material other materials cost $810 per radio.
Assembly labour these are skilled people who are difficult to recruit and retain. Edward Co has more
staff of this type than needed but is prepared to carry this extra cost in return for the security it gives the
business. It takes 30 minutes to assemble a radio and the assembly workers are paid $1260 per hour. It is
estimated that 10% of hours paid to the assembly workers is for idle time.
Production Overheads recent historic cost analysis has revealed the following production overhead
data:
Total production overhead Total assembly labour hours
$
Month 1 620,000 19,000
Month 2 700,000 23,000
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Fixed production overheads are absorbed on an assembly hour basis based on normal annual activity
levels. In a typical year 240,000 assembly hours will be worked by Edward Co.
Required:
(d) Calculate the expected cost per unit for the radio and identify any cost gap that might exist.
(13 marks)
Q2. Big Cheese Chairs (BCC) manufactures and sells executive leather chairs. They are considering a new
design of massaging chair to launch into the competitive market in which they operate.
They have carried out an investigation in the market and using a target costing system have targeted a
competitive selling price of $120 for the chair. BCC wants a margin on selling price of 20% (ignoring any
overheads).
The frame and massage mechanism will be bought in for $51 per chair and BCC will upholster it in leather
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and assemble it ready for despatch.
Leather costs $10 per metre and two metres are needed for a complete chair although 20% of all leather
is wasted in the upholstery process.
e
The upholstery and assembly process will be subject to a learning effect as the workers get used to the
new design.
BCC estimates that the first chair will take two hours to prepare but this will be subject to a learning rate
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(LR) of 95%. The learning improvement will stop once 128 chairs have been made and the time for the
128th chair will be the time for all subsequent chairs. The cost of labour is $15 per hour.
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The learning formula is shown on the formula sheet and at the 95% learning rate the value of b is
0074000581.
Required:
(a) Calculate the average cost for the first 128 chairs made and identify any cost gap that may be
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present at that stage. (8 marks)
(b) Assuming that a cost gap for the chair exists suggest four ways in which it could be closed.
(6 marks)
The production manager denies any claims that a cost gap exists and has stated that the cost of the 128th
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chair will be low enough to yield the required margin.
(c) Calculate the cost of the 128th chair made and state whether the target cost is being achieved
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on the 128th chair. (6 marks)
a i
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Life Cycle Costing
Is the profiling of cost over a products life , including the pre- production stage
Tracks and accumulates the actual costs and revenues attributable to each product from inception to
abandonment
Enables a products true profitability to be determined at the end of its economic life
Stages of product life cycle
1) Pre-Production/Product development stage
A high level of setup costs will be incurred in this stage (pre-production costs), including research
and development (R&D), product design and building of production facilities.
2) Launch/ market development stage
Success depends on awareness and trial of the product by consumers, so this stage is likely to be
accompanied by extensive marketing ad promotion costs.
3) Growth stage
Marketing and promotion will continue through this stage
In this stage sales volume increases dramatically and unit costs fall as fixed costs are recovered
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over greater volume.
4) Maturity stage
Initially profits will continue to increase, as initial setup and fixed costs are recovered.
Marketing and distribution economies are achieved
However, price competition and product differentiation will start to erode profitability as firms
compete for the limited new customers remaining
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5) Decline stage
Marketing costs are usually cut as the product is phased out
Production economies may be lost as volumes fall
Meanwhile, a replacement product will need to have been developed, incurring new levels of R&D
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and other product setup costs.
Alternatively additional development costs may be incurred to refine the model to extend the life-
cycle (this is typical with cars where product evolution is the norm rather than product
revolution)
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Q1. W has recently completed the development and testing of a new product which has cost $400,000. It
has also bought a machine to produce the new product costing $150,000. The production machine is
capable of producing 1,000 units of the product per month and is not expected to have a residual value
due to its specialised nature.
The company has decided that the unit selling prices it will charge will change with the cumulative
numbers of units sold as follows:
Cumulative sales units Selling price
$ per unit in this band
0 to 2,000 100
2,001 to 7,000 80
7,001 to 14,500 70
s
14,501 to 54,500 60
54,501 and above 40
Based on these selling prices, it is expected that sales demand will be as shown below:
e
Months Sales demand per month
(units)
1 - 10 200
11 - 20
21 - 30
31 - 70
71 - 80
81 - 90
91 - 100
500
750
1,000
800
600
400
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101 - 110 200
Thereafter NIL
Unit variable costs are expected to be as follows:
$ per unit
a
First 2,000 units 50
Next 12,500 units 40
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i
Thereafter 30
W operates a Just in Time (JIT) purchasing and production system and operates its business on a cash
a
basis. First 10 months are considered to be introduction stage, next 20 months are considered to be
growth stage.
Required:
Z
(a) Prepare cash flow statement for four stages of the products life cycle. Ignore the time value of money.
(b) Explain, using your answer to (a) above and the data provided, the possible reasons for the changes in
costs and selling prices during the life cycle of the product.
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Q2. Wargrin designs, develops and sells many PC games. Games have a short lifecycle lasting around
three years only. Performance of the games is measured by reference to the profits made in each of the
expected three years of popularity. Wargrin accepts a net profit of 35% of turnover as reasonable. A rate
of contribution (sales price less variable cost) of 75% is also considered acceptable. Wargrin has a large
centralised development department which carries out all the design work before it passes the completed
game to the sales and distribution department to market and distribute the product.
Wargrin has developed a brand new game called Stealth and this has the following budgeted
performance figures. The selling price of Stealth will be a constant $30 per game. Analysis of the costs
show that at a volume of 10,000 units a total cost of $130,000 is expected. However at a volume of 14,000
units a total cost of $150,000 is expected. If volumes exceed 15,000 units the fixed costs will increase by
50%.
Stealths budgeted volumes are as follows:
Year 1 Year 2 Year 3
Sales volume 8,000 units 16,000 units 4,000 units
In addition, marketing costs for Stealth will be $60,000 in year one and $40,000 in year two. Design and
development costs are all incurred before the game is launched and has cost $300,000 for Stealth. These
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costs are written off to the income statement as incurred (i.e. before year 1 above).
Required:
(a) Explain the principles behind lifecycle costing and briefly state why Wargrin in particular should
consider these lifecycle principles. (4 marks)
(b) Produce the budgeted results for the game Stealth and briefly assess the games expected
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performance, taking into account the whole lifecycle of the game. (9 marks)
(c) Explain why incremental budgeting is a common method of budgeting and outline the main
problems with such an approach. (6 marks)
(d) Discuss the extent to which a meaningful standard cost can be set for games produced by
Wargrin. You should consider each of the cost classifications mentioned above.
A
(6 marks)
(25 marks)
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Throughput Accounting
The key factor approach described in the previous section is very sensible, and the throughput approach
is effectively the same. However, there are two main concepts of throughput accounting which result in us
amending the approach.
The main concepts of throughput accounting are:
in the short run, all costs in the factory are likely to be fixed with the exception of materials costs
in a JIT environment then we should be attempting to eliminate stocks. Use of a limited resource in
production of stocks should be avoided and therefore any work-in-progress should be valued at only the
material cost
s
Definitions:
Throughput = sales revenue material cost
Total factory costs = all production costs except materials
Return per factory hour =
Cost per factory hour =
Throughput accounting ratio =

Throughput
Time on key resource
Total factory cost
Total time available on key resource
e
.
Return per factory hour

e
n
Cost per factory hour
The TA ratio should be greater than 1 if a product is to be viable. Priority should be given to those
products which generate the highest TA ratios.
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Q1. Ride ltd is engaged in the manufacturing and marketing of bicycles. Two types of bicycles are
produced. These are Roadstar which is designed for use on roads and the Everest which is a bicycle
designed for use in mountainous areas. The following information relates to the year ending 31st
December 2005.
a
(1) The following selling price and cost data is as follows:
Roadstar Everest
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Material cost 80 100
Variable production cost 20 60
a
(2) Fixed production overheads attributable to the manufacturing of bicycles will amount to
4,050,000.
(3) Expected demand is as follows
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Roadstar 150,000
Evereast 70,000
(4) Each bicycle is completed in the finishing department. The number of each type of bicycle that
can be completed in one hour in the finishing department is as follows:
Roadstar 6.25
Everest 5.00
(5) Ride ltd operates a JIT manufacturing system with regards to the manufacture of bicycle and aims
to hold very little inventory of WIP and no inventory of finished goods.
Required:
(a) Using marginal costing principles, calculate the mix (units) of each type of bicycle which will
maximize net profit and sate the value of profit.
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(b) Calculate throughput accounting ratio for each type of bicycle and briefly discuss when it is worth
producing a producing a product where throughput accounting principles are in operation. Your
answer should assume that the variable overhead cost amounting to 4,800,000 incurred as a
result of chosen product mix in part (a) is fixed in the short term.
(c) Using throughput accounting principles, advice management of the quantities of each type of
bicycle that should be manufactured which will maximize net profit and prepare a projection of
the net profit that would be earned by Ride Ltd in the year ending 31st December 2005.
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A
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Environmental Management Accounting (EMA)
Environmental management accounting is simply a specialize part of the management accounts that
focuses on things such as the cost of energy and water and the disposal of waste and effluent. It is
important to note at this point that the focus of environmental management accounting is not all on
purely financial costs. It includes consideration of matters such as the costs vs benefits of buying from
suppliers who are more environmentally aware, or the effect on the public image of the company from
failure to comply with environmental regulations.
Environmental management accounting uses some standard accountancy techniques to identify, analyse,
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manage and hopefully reduce environmental costs in a way that provides mutual benefit to the company
and the environment, although sometimes it is only possible to provide benefit to one of these parties.
For example, activity-based costing may be used to ascertain more accurately the costs of washing towels
e
at a gym. The energy used to power the washing machine is an environmental cost; the cost driver is
washing.
e
Once the costs have been identified and information accumulated on how many customers are using the
gym, it may actually be established that some customers are using more than one towel on a single visit
to the gym. The gym could drive forward change by informing customers that they need to pay for a
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second towel if they need one. Given that this approach will be seen as environmentally-friendly, most
customers would not argue with its introduction. Nor would most of them want to pay for the cost of a
second towel. The costs to be saved by the company from this new policy would include both the energy
savings from having to run fewer washing machines all the time and the staff costs of those people
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collecting the towels and operating the machines. Presumably, since the towels are being washed less
frequently, they will need to be replaced by new ones less often as well.
In addition to these savings to the company, however, are the all-important savings to the environment
a
since less power and cotton (or whatever materials the towels are made from) is now being used, and the
scarce resources of our planet are therefore being conserved. Lastly, the gym is also seen as an
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environmentally friendly organisation and this, in turn, may attract more customers and increase revenues.
Just a little bit of management accounting (and common sense!) can achieve all these things. While I
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always like to minimise the use of jargon, in order to be fully versed on what environmental management
accounting is really seen by the profession as encompassing today, it is necessary to consider a couple of
the most widely accepted definitions of it.
accounting as:
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In 1998, the International Federation of Accountants (IFAC) originally defined environmental management
The management of environmental and economic performance through the development and
implementation of appropriate environment-related accounting systems and practices. While this may
include reporting and auditing in some companies, environmental management accounting typically
involves lifecycle costing, full cost accounting, benefits assessment, and strategic planning for environmental
management.
Then, in 2001, The United Nations Division for Sustainable Development (UNDSD) emphasised their belief
that environmental management accounting systems generate information for internal decision making
rather than external decision making. This is in line with my statement at the beginning of this article that
EMA is a subset of environmental accounting as a whole.
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The UNDSD make what became a widely accepted distinction between two types of information: physical
information and monetary information. Hence, they broadly defined EMA to be the identification,
collection, analysis and use of two types of information for internal decision making:
physical information on the use, flows and destinies of energy, water and materials (including wastes)
monetary information on environment-related cost, earnings and savings.
This definition was then adopted by an international consensus group of over 30 nations and thus
eventually adopted by IFAC in its 2005 international guidance document on environmental management
accounting.
Hansen and Mendoza (1999) stated that environmental costs are incurred because of poor quality
controls. Therefore, they advocate the use of a periodical environmental cost report that is produced in
the format of a cost of quality report, with each category of cost being expressed as a percentage of sales
revenues or operating costs so that comparisons can be made between different periods and/or
organisations. The categories of costs would be as follows
Environmental prevention costs: the costs of activities undertaken to prevent the production of waste.
Environmental detection costs: costs incurred to ensure that the organisation complies with
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regulations and voluntary standards.
Environmental internal failure costs: costs incurred from performing activities that have produced
contaminants and waste that have not been discharged into the environment.
Environmental external failure costs: costs incurred on activities performed after discharging waste into
the environment.
It is clear from the suggested format of this quality type report that Hansen and Mendozas definition of
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environmental cost is relatively narrow.
Managing environmental costs
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There are three main reasons why the management of environmental costs is becoming increasingly
important in organisations.
First, society as a whole has become more environmentally aware, with people becoming increasingly
aware about the carbon footprint and recycling taking place now in many countries. A carbon footprint
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(as defined by the Carbon Trust) measures the total greenhouse gas emissions caused directly and
indirectly by a person, organisation, event or product. Companies are finding that they can increase their
appeal to customers by portraying themselves as environmentally responsible.
Second, environmental costs are becoming huge for some companies, particularly those operating in
highly industrialized sectors such as oil production. In some cases, these costs can amount to more than
20% of operating costs. Such significant costs need to be managed.
Third, regulation is increasing worldwide at a rapid pace, with penalties for non-compliance also
increasing accordingly. In the largest ever seizure related to an environmental conviction in the UK, a plant
hire firm, John Craxford Plant Hire Ltd, had to not only pay 85,000 in costs and fines but also got 1.2m
of its assets seized. This was because it had illegally buried waste and also breached its waste and
pollution permits. And its not just the companies that need to worry.
Officers of the company and even junior employees could find themselves facing criminal prosecution for
knowingly breaching environmental regulations. But the management of environmental costs can be a
difficult process. This is because first, just as EMA is difficult to define, so too are the actual costs involved.
Second, having defined them, some of the costs are difficult to separate out and identify. Third, the costs
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can need to be controlled but this can only be done if they have been correctly identified in the first place.
Each of these issues is dealt with in turn below.
Defining environmental costs

Many organisations vary in their definition of environmental costs. It is neither possible nor desirable to
consider all of the great range of definitions adopted. A useful cost categorisation, however, is that
provided by the US Environmental Protection Agency in 1998. They stated that the definition of
environmental costs depended on how an organization intended on using the information. They made a
distinction between four types of costs:
conventional costs: raw material and energy costs having environmental relevance
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potentially hidden costs: costs captured by accounting systems but then losing their identity in
general overheads
contingent costs: costs to be incurred at a future date, eg clean up costs
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image and relationship costs: costs that, by their nature, are intangible, for example, the costs of
preparing environmental reports.
The UNDSD, on the other hand, described environmental costs as comprising of:
e
costs incurred to protect the environment, eg measures taken to prevent pollution and
costs of wasted material, capital and labour, ie inefficiencies in the production process.
Neither of these definitions contradict each other; they just look at the costs from slightly different angles.
Identifying environmental costs
n
A
Much of the information that is needed to prepare environmental management accounts could actually
be found in a business general ledger. A close review of it should reveal the costs of materials, utilities
and waste disposal, at the least. The main problem is, however, that most of the costs will have to be
found within the category of general overheads if they are to be accurately identified. Identifying them
could be a lengthy process, particularly in a large organisation. The fact that environmental costs are often
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hidden in this way makes it difficult for management to identify opportunities to cut environmental costs
and yet it is crucial that they do so in a world which is becoming increasingly regulated and where scarce
resources are becoming scarcer.
a i
It is equally important to allocate environmental costs to the processes or products which give rise to
them. Only by doing this can an organisation make well-informed business decisions. For example, a
pharmaceutical company may be deciding whether to continue with the production of one of its drugs. In
order to incorporate environmental aspects into its decision, it needs to know exactly how many products
are input into the process compared to its outputs; how much waste is created during the process; how
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much labour and fuel is used in making the drug; how much packaging the drug uses and what
percentage of that is recyclable etc Only by identifying these costs and allocating them to the product can
an informed decision be made about the environmental effects of continued production.
In 2003, the UNDSD identified four management accounting techniques for the identification and
allocation of environmental costs: input/ outflow analysis, flow cost accounting, activity based costing and
lifecycle costing. These are referred to later under different methods of accounting for environmental
costs.
Controlling environmental costs
It is only after environmental costs have been defined, identified and allocated that a business can begin
the task of trying to control them.
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As we have already discussed, environmental costs will vary greatly from business to business and, to be
honest, a lot of the environmental costs that a large, highly industrialized business will incur will be
difficult for the average person to understand, since that person wont have a detailed knowledge of the
industry concerned. I will therefore use some basic examples of easy-to-understand environmental costs
when considering how an organisation may go about controlling such costs. Let us consider an
organisation whose main environmental costs are as follows:
waste and effluent disposal
water consumption
energy
transport and travel
consumables and raw materials.
Each of these costs is considered in turn below.
Waste
There are lots of environmental costs associated with waste. For example, the costs of unused raw
materials and disposal; taxes for landfill; fines for compliance failures such as pollution. It is possible to
identify how much material is wasted in production by using the mass balance approach, whereby the
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weight of materials bought is compared to the product yield. From this process, potential cost savings
may be identified.
In addition to these monetary costs to the organisation, waste has environmental costs in terms of lost
land resources (because waste has been buried) and the generation of greenhouse gases in the form of
methane.
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Water
You have probably never thought about it but businesses actually pay for water twice first, to buy it and
second, to dispose of it. If savings are to be made in terms of reduced water bills, it is important for
organisations to identify where water is used and how consumption can be decreased.
A
Energy
Often, energy costs can be reduced significantly at very little cost. Environmental management accounts
may help to identify inefficiencies and wasteful practices and, therefore, opportunities for cost savings.
Transport and travel
C
Again, environmental management accounting can often help to identify savings in terms of business
travel and transport of goods and materials. At a simple level, a business can invest in more fuel-efficient
vehicles, for example.
Consumables and raw materials
These costs are usually easy to identify and discussions with senior managers may help to identify where
savings can be made. For example, toner cartridges for printers could be refilled rather than replaced.
This should produce a saving both in terms of the financial cost for the organisation and a waste saving
for the environment (toner cartridges are difficult to dispose of and less waste is created this way).
Accounting for environmental costs
Internal reporting of environmental costs, which has already been discussed in the introduction.
Management accounting techniques for the identification and allocation of environmental costs: namely
input/outflow analysis,
flow cost accounting,
activity-based costing and
lifecycle costing.
Page 44 of 106
Input/outflow analysis
This technique records material inflows and balances this with outflows on the basis that, what comes in,
must go out. So, if 100kg of materials have been bought and only 80kg of materials have been produced,
for example, then the 20kg difference must be accounted for in some way. It may be, for example, that
10% of it has been sold as scrap and 90% of it is waste. By accounting for outputs in this way, both in
terms of physical quantities and, at the end of the process, in monetary terms too, businesses are forced
to focus on environmental costs.
Flow cost accounting
This technique uses not only material flows but also the organizational structure. It makes material flows
transparent by looking at the physical quantities involved, their costs and their value. It divides the
s
material flows into three categories: material, system and delivery and disposal. The values and costs of
each of these three flows are then calculated. The aim of flow cost accounting is to reduce the quantity of
materials which, as well as having a positive effect on the environment, should have a positive effect on a
e
business total costs in the long run. between
Activity-based costing
ABC allocates internal costs to cost centres and cost drivers on the basis of the activities that give rise to
e
the costs. In an environmental accounting context, it distinguishes between environment-related costs,
which can be attributed to joint cost centres, and environmentdriven costs, which tend to be hidden on
general overheads.
Lifecycle costing
n
Within the context of environmental accounting, lifecycle costing is a technique which requires the full
A
environmental consequences, and, therefore, costs, arising from production of a product to be taken
account across its whole lifecycle, literally from cradle to grave.
r a
Please read following examiners article from ACCA website by using
http://www.accaglobal.com/students/acca/paperf5/syllabus_a/

ABC
a i
Target costing and life cycle costing
Throughput costing (ignore backflush costing because it has been excluded from F5
syllabus)
Z
CVP
EMA
Page 45 of 106
Section E
Performance Measurement
Q1. BLA Ltd is a design consultancy that provides advice to clients regarding property maintenance and
improvements.
Three types of consultant are employed by BLA Ltd. These are:
(1) Architectural consultants who provide advice with regard to exterior building improvements.
(2) Interior design consultants who provide advice regarding interior design, and
(3) Landscape consultants who provide advice regarding landscaping of properties and garden design
improvements.
BLA Ltd does not undertake building work on behalf of its clients and will only recommend contractors
that undertake the three types of work when requested to do so by its clients. The following information
is relevant:
(i) Each consultation, other than those detailed in notes (iv) and (v), is charged at a rate of 150 per
consultation.
S
(ii) The consultants are each paid a fixed annual salary of 45,000. In addition they receive a bonus of 40%
of the fee income generated in excess of budget. The bonus is shared equally among the consultants
employed by BLA Ltd on 31 October in the year to which the bonus relates.
(iii) Other operating expenses (excluding the salaries of the consultants) were budgeted at 2,550,000 for
the year to 31 October 2003. The actual amount incurred in respect of the year to 31 October 2003 was
M
2,805,000, which excludes payments to subcontractors per note (vii) below.
(iv) In an attempt to gain new business, consultants may undertake consultations on a no-fee basis. Such
consultations are regarded as Business Development Activity by the management of BLA Ltd.
(v) Consultants will sometimes undertake remedial consultations with clients who experience problems at
the time when work commences on each clients site. Remedial consultations are also provided on a non-
A
chargeable, i.e. no fee basis.
(vi) In November 2002, BLA Ltd purchased state of the art business software for use by its consultants in
simulating design improvements. The software was used throughout the year by consultants who
specialise in landscape and garden design. It is now planned to introduce the use of the software by the
C
other categories of consultant within BLA Ltd.
(vii) BLA Ltd has a policy of maintaining staff at a level of 45 consultants on an ongoing basis, irrespective
of fluctuations in the level of demand. Also, BLA Ltd has retained links with retired consultants and will
occasionally subcontract work to them at a cost of 150 per consultation, if current full-time consultants
within a particular category are fully utilised. During the year ended 31 October 2003 subcontractors only
undertook nonchargeable client consultations.
Page 46 of 106
BLA Ltd: Sundry statistics for year ended 31 October 2003
Budget Actual
Number of consultants by category:
Exterior design 18 15
Interior design 18 18
Landscape & garden design 9 12
Total client enquiries:
New business 67,500 84,000
Repeat business 32,400 28,000
Number of chargeable client consultations:
s
New business 24,300 22,400
Repeat business 16,200 19,600
Number of non-chargeable client consultations
e
undertaken by BLA consultants:
Number of business development consultations 1,035 1,200
Number of remedial consultations 45 405
Number of non-chargeable client consultations
undertaken by subcontractors:
Other statistics:
Number of complaints
Required:
324
n e 120
630
(a) Fitzgerald and Moon have suggested that business performance should be measured in a number of
A
ways. Assess the performance of BLA with respect to the following dimensions
i. Financial performance
ii. Competitiveness
iii. Service quality
a
iv. Flexibility
v. Resource utilization
r
vi. Innovation
i
(b) Briefly discuss THREE factors that should be considered in the determination of expected
standards in a performance measurement system. (5 marks)
Z a
Page 47 of 106
Q2. The following information relates to Preston Financial Services, an accounting practice. The business
specialises in providing accounting and taxation work for dentists and doctors. In the main the clients are
wealthy, self-employed and have an average age of 52.
The business was founded by and is wholly owned by Richard Preston, a dominant and aggressive sole
practitioner. He feels that promotion of new products to his clients would be likely to upset the
conservative nature of his dentists and doctors and, as a result, the business has been managed with
similar products year on year.
You have been provided with financial information relating to the practice in appendix 1. In appendix 2,
you have been provided with non-financial information which is based on the balanced scorecard format.
Appendix 1: Financial information
Current year Previous year
Turnover ($000) 945 900
Net profit ($000) 187 180
Average cash balances ($000) 21 20
Average trade receivables days (industry average 30 days) 18 days 22 days
Inflation rate (%) 3 3
Appendix 2: Balanced Scorecard (extract)
S
Internal Business Processes
Error rates in jobs done 16% 10%
Average job completion time 7 weeks 10 weeks
Customer Knowledge
M
Number of customers 1220 1500
Average fee levels ($) 775 600
Market Share 14% 20%
A
Learning and Growth
Percentage of revenue from non-core work 4% 5%
Industry average of the proportion of revenue from non-core work
in accounting practices 30% 25%
C
Employee retention rate 60% 80%
Notes
1. Error rates measure the number of jobs with mistakes made by staff as a proportion of the number of
clients serviced
2. Core work is defined as being accountancy and taxation. Non-core work is defined primarily as pension
advice and business consultancy. Non core work is traditionally high margin work
Required:
(a) Using the information in appendix 1 only, comment on the financial performance of the business
(briefly consider growth, profitability, liquidity and credit management). (8 marks)
(b) Explain why non financial information, such as the type shown in appendix 2, is likely to give a better
indication of the likely future success of the business than the financial information given in appendix 1.
(5 marks)
(c) Using the data given in appendix 2 comment on the performance of the business. Include comments
on internal business processes, customer knowledge and learning/growth, separately, and provide a
concluding comment on the overall performance of the business. (12 marks)
Page 48 of 106
Q3. Pace Company (PC) run a large number of wholesale stores and is increasing the number of these
stores all the time.
It measures the performance of each store on the basis of a target return on investment (ROI) of 15%.
Store managers get a bonus of 10% of their salary if their stores annual ROI exceeds the target each year.
Once a store is built there is very little further capital expenditure until a full four years have passed.
PC has a store (store W) in the west of the country. Store W has historic financial data as follows over the
past four years:
2005 2006 2007 2008
Sales ($000) 200 200 180 170
Gross profit ($000) 80 70 63 51
Net profit ($000) 13 14 10 8
s
Net assets at start of year ($000) 100 80 60 40
The market in which PC operates has been growing steadily. Typically, PCs stores generate a 40% gross
profit margin.
e
Required:
(a) Discuss the past financial performance of store W using ROI and any other measure you feel
appropriate and, using your findings, discuss whether the ROI correctly reflects Store Ws actual
performance.
bonuses more frequently.

e
(b) Explain how a manager in store W might have been able to manipulate the results so as to gain
n
(8 marks)
(4 marks)
PC has another store (store S) about to open in the south of the country. It has asked you for help in
calculating the gross profit, net profit and ROI it can expect over each of the next four years. The following
information is provided:
A
Sales volume in the first year will be 18,000 units. Sales volume will grow at the rate of 10% for years two
and three but no further growth is expected in year 4. Sales price will start at $12 per unit for the first two
years but then reduce by 5% per annum for each of the next two years.
Gross profit will start at 40% but will reduce as the sales price reduces. All purchase prices on goods for
a
resale will remain constant for the four years.
Overheads, including depreciation, will be $70,000 for the first two years rising to $80,000 in years three
r
and four.
i
Store S requires an investment of $100,000 at the start of its first year of trading.
PC depreciates non-current assets at the rate of 25% of cost. No residual value is expected on these
assets.
a
Required:
(c) Calculate (in columnar form) the revenue, gross profit, net profit and ROI of store S over each of
its first four years. (9 marks)
Z
(d) Calculate the minimum sales volume required in year 4 (assuming all other variables remain
unchanged) to earn the manager of S a bonus in that year. (4 marks)
(25 marks)
Q4. Ties Only is a new business, selling high quality imported mens ties via the internet. The managers,
who also own the company, are young and inexperienced but they are prepared to take risks. They are
confident that importing quality ties and selling via a website will be successful and that the business will
grow quickly. This is despite the well recognised fact that selling clothing is a very competitive business.
They were prepared for a loss-making start and decided to pay themselves modest salaries (included in
administration expenses in table 1 below) and pay no dividends for the foreseeable future.
The owners are so convinced that growth will quickly follow that they have invested enough money in
website server development to ensure that the server can handle the very high levels of predicted growth.
Page 49 of 106
All website development costs were written off as incurred in the internal management accounts that are
shown below in table 1.
Significant expenditure on marketing was incurred in the first two quarters to launch both the website and
new products. It is not expected that marketing expenditure will continue to be as high in the future.
Customers can buy a variety of styles, patterns and colours of ties at different prices.
The businesss trading results for the first two quarters of trade are shown below in table 1
Table 1
Quarter 1 Quarter 2
$ $ $ $
Sales 420,000 680,000
less Cost of Sales (201,600) (340,680)
Gross Profit 218,400 339,320
less expenses
Website development 120,000 90,000
Administration 100,500 150,640
Distribution 20,763 33,320
Launch marketing 60,000 40,800
S
Other variable expenses 50,000 80,000
Total expenses (351,263) (394,760)
Loss for quarter (132,863) (55,440)
Required:
(a) Assess the financial performance of the business during its first two quarters using only the
M
data in table 1 above. (12 marks)
(b) Briefly consider whether the losses made by the business in the first two quarters are a true
reflection of the current and likely future performance of the business. (4 marks)
The owners are well aware of the importance of non-financial indicators of success and therefore have
A
identified a small number of measures to focus on. These are measured monthly and then combined to
produce a quarterly management report.
The data for the first two quarters management reports is shown below:
Table 2
C
Quarter 1 Quarter 2
Website hits* 690,789 863,492
Number of ties sold 27,631 38,857
On time delivery 95% 89%
Sales returns 12% 18%
System downtime 2% 4%
* A website hit is automatically counted each time a visitor to the website opens the home page of Ties
Only.
The industry average conversion rate for website hits to number of ties sold is 32%. The industry average
sales return rate for internet-based clothing sales is 13%.
Required:
Comment on each of the non-financial data in table 2 above taking into account, where
appropriate, the industry averages provided, providing your assessment of the performance of the
business. (9 marks)
Page 50 of 106
Q5. Bridgewater Co provides training courses for many of the mainstream software packages on the
market.
The business has many divisions within Waterland, the one country in which it operates. The senior
managers of Bridgewater Co have very clear objectives for the divisions and these are communicated to
divisional managers on appointment and subsequently in quarterly and annual reviews. These are:
1. Each quarter, sales should grow and annual sales should exceed budget
2. Trainer (lecture staff) costs should not exceed $180 per teaching day
3. Room hire costs should not exceed $90 per teaching day
4. Each division should meet its budget for profit per quarter and annually
It is known that managers will be promoted based on their ability to meet these targets. A member of the
senior management is to retire after quarter 2 of the current financial year, which has just begun. The
s
divisional managers anticipate that one of them may be promoted at the beginning of quarter 3 if their
performance is good enough.
The manager of the Northwest division is concerned that his chances of promotion could be damaged by
e
the expected performance of his division. He is a firm believer in quality and he thinks that if a business
gets this right, growth and success will eventually follow.
The current quarterly forecasts, along with the original budgeted profit for the Northwest division, are as
follows:
Sales
less:
Trainers
Q1
$000
400
80
Q2
$000
360
72
Q3
n
500
100
e
$000
Q4
$000
600
120
Total
$000
1860
372
A
Room hire 40 36 50 60 186
Staff training 10 10 10 10 40
Other costs 30 17 60 70 177
Forecast net profit 240 225 280 340 1085
a
Original budgeted profit 250 260 270 280 1060
Annual sales budget 1800
i
Teaching days 40 36 50 60
Required:
(a) Assess the financial performance of the Northwest division against its targets and reach a
a
conclusion as to the promotion prospects of the divisional manager (8 marks)
The manager of the Northwest division has been considering a few steps to improve the performance of
his division.
Z
Voucher scheme
As a sales promotion, vouchers will be sold for $125 each, a substantial discount on normal prices. These
vouchers will entitle the holder to attend four training sessions on software of their choice. They can
attend when they want to but are advised that one training session per quarter is sensible. The manager is
confident that if the promotion took place immediately, he could sell 80 vouchers and that customer
would follow the advice given to attend one session per quarter. All voucher holders would attend
planned existing courses and all will be new customers.
Software upgrade
A new important software programme has recently been launched for which there could be a market for
training courses. Demonstration programs can be bought for $1,800 in quarter 1. Staff training would be
needed, costing $500 in each of quarters 1 and 2 but in quarters 3 and 4 extra courses could be offered
selling this training. Assuming similar class sizes and the usual sales prices, extra sales revenue amounting
Page 51 of 106
to 20% of normal sales are expected (measured before the voucher promotion above). The manager is
keen to run these courses at the same tutorial and room standards as he normally provides. Software
expenditure is written off in the income statement as incurred.
Delaying payments to trainers
The manager is considering delaying payment to the trainers. He thinks that, since his commitment to
quality could cause him to miss out on a well deserved promotion, the trainers owe him a favour. He
intends to delay payment on 50% of all invoices received from the trainers in the first two quarters, paying
them one month later than is usual.
Required:
(b) Revise the forecasts to take account of all three of the proposed changes. (7 marks)
(c) Comment on each of the proposed steps and reach a conclusion as to whether, if all the
proposals were taken together, the manager will improve his chances of promotion. (6 marks)
Q6. Jump has a network of sports clubs which is managed by local managers reporting to the main board.
The local managers have a lot of autonomy and are able to vary employment contracts with staff and
offer discounts for membership fees and personal training sessions. They also control their own
S
maintenance budget but do not have control over large amounts of capital expenditure.
A local managers performance and bonus is assessed relative to three targets. For every one of these
three targets that is reached in an individual quarter, $400 is added to the managers bonus, which is paid
at the end of the year. The maximum bonus per year is therefore based on 12 targets (three targets in
each of the four quarters of the year).
Accordingly the maximum bonus that could be earned is 12 x $400 = $4,800, which represents 40% of the
M
basic salary of a local manager. Jump has a 31 March year end.
The performance data for one of the sports clubs for the last four quarters is as follows
A
Agreed targets are:
C
1. Staff must be on time over 95% of the time (no penalty is made when staff are absent from work)
2. On average 60% of members must use the clubs facilities regularly by visiting at least 12 times per
quarter
3. On average 10% of members must book a personal training session each quarter
Required:
(a) Calculate the amount of bonus that the manager should expect to be paid for the latest
financial year. (6 marks)
(b) Discuss to what extent the targets set are controllable by the local manager (you are required
to make a case for both sides of the argument). (9 marks)
(c) Describe two methods as to how a manager with access to the accounting and other records
could unethically manipulate the situation so as to gain a greater bonus. (5 marks)
(20 marks)
Page 52 of 106
Q7. Thatcher International Park (TIP) is a theme park and has for many years been a successful business,
which has traded profitably. About three years ago the directors decided to capitalise on their success and
reduced the expenditure made on new thrill rides, reduced routine maintenance where possible (deciding
instead to repair equipment when it broke down) and made a commitment to regularly increase
admission prices. Once an admission price is paid customers can use any of the facilities and rides for free.
These steps increased profits considerably, enabling good dividends to be paid to the owners and
bonuses to the directors. The last two years of financial results are shown below.
e s
Required:
n e
A
(a) Assess the financial performance of TIP using the information given above. (14 marks)
During the early part of 2008 TIP employed a newly qualified management accountant. He quickly
became concerned about the potential performance of TIP and to investigate his concerns he started to
gather data to measure some non-financial measures of success. The data he has gathered is shown
a
below:
Table 1
r
2008 2009
Hours lost due to breakdown of rides (see note 1) 9,000 hours 32,000 hours
i
Average waiting time per ride 20 minutes 30 minutes
Note 1: TIP has 50 rides of different types. It is open 360 days of the year for 10 hours each day
Required:
a
(b) Assess the quality of the service that TIP provides to its customers using Table 1 and any other
relevant data and indicate the risks it is likely to face if it continues with its current policies.
Z
(6 marks)
Page 53 of 106
Q8. Oliver is the owner and manager of Olivers Salon which is a quality hairdresser that experiences high
levels of competition. The salon traditionally provided a range of hair services to female clients only,
including cuts, colouring and straightening. A year ago, at the start of his 2009 financial year, Oliver
decided to expand his operations to include the hairdressing needs of male clients. Male hairdressing
prices are lower, the work simpler (mainly hair cuts only) and so the time taken per male client is much
less.
The prices for the female clients were not increased during the whole of 2008 and 2009 and the mix of
services provided for female clients in the two years was the same.
The latest financial results are as follows:
2008 2009
$ $ $ $
Sales 200,000 238,500
Less cost of sales:
Hairdressing staff costs 65,000 91,000
Hair products female 29,000 27,000
Hair products male 8,000

S
94,000 126,000
Gross profit 106,000 112,500
Less expenses:
Rent 10,000 10,000
Administration salaries 9,000 9,500
M
Electricity 7,000 8,000
Advertising 2,000 5,000
Total expenses 28,000 32,500
Profit 78,000 80,000
A
Oliver is disappointed with his financial results. He thinks the salon is much busier than a year ago and
was expecting more profit. He has noted the following extra information:
1. Some female clients complained about the change in atmosphere following the introduction of male
services, which created tension in the salon.
2. Two new staff were recruited at the start of 2009. The first was a junior hairdresser to support the
C
specialist hairdressers for the female clients. She was appointed on a salary of $9,000 per annum. The
second new staff member was a specialist hairdresser for the male clients. There were no increases in pay
for existing staff at the start of 2009 after a big rise at the start of 2008 which was designed to cover two
years worth of increases.
Oliver introduced some non-financial measures of success two years ago.
2008 2009
Number of complaints 12 46
Number of male client visits 0 3,425
Number of female client visits 8,000 6,800
Number of specialist hairdressers for female clients 4 5
Number of specialist hairdressers for male clients 0 1
Required:
(a) Calculate the average price for hair services per male and female client for each of the years
2008 and 2009. (3 marks)
(b) Assess the financial performance of the Salon using the data above. (11 marks)
(c) Analyse and comment on the non-financial performance of Olivers business, under the
headings of quality and resource utilisation. (6 marks)
Page 54 of 106
Q9. The Accountancy Teaching Co (AT Co) is a company specialising in the provision of accountancy
tuition courses in the private sector. It makes up its accounts to 30 November each year. In the year
ending 30 November 2009, it held 60% of market share. However, over the last twelve months, the
accountancy tuition market in general has faced a 20% decline in demand for accountancy training
leading to smaller class sizes on courses. In 2009 and before, AT Co suffered from an ongoing problem
with staff retention, which had a knock-on effect on the quality of service provided to students. Following
the completion of developments that have been ongoing for some time, in 2010 the company was able to
offer a far-improved service to students. The developments included:
A new dedicated 24 hour student helpline
An interactive website providing instant support to students
A new training programme for staff
s
An electronic student enrolment system
An electronic marking system for the marking of students progress tests. The costs of marking
electronically were expected to be $4 million less in 2010 than marking on paper. Marking expenditure is
e
always included in cost of sales
n e
A
r a
i
On 1 December 2009, management asked all freelance lecturers to reduce their fees by at least 10% with
immediate effect (freelance lecturers are not employees of the company but are used to teach students
when there are not enough of AT Cos own lecturers to meet tuition needs). All employees were also told
a
that they would not receive a pay rise for at least one year. Total lecture staff costs (including freelance
lecturers) were $41663 million in 2009 and were included in cost of sales, as is always the case. Freelance
lecturer costs represented 35% of these total lecture staff costs. In 2010 freelance lecture costs were
Z
$12394 million. No reduction was made to course prices in the year and the mix of trainees studying for
the different qualifications remained the same. The same type and number of courses were run in both
2009 and 2010 and the percentage of these courses that was run by freelance lecturers as opposed to
employed staff also remained the same. Due to the nature of the business, non-financial performance
indicators are also used to assess performance, as detailed below.
Page 55 of 106
Required:
Assess the performance of the business in 2010 using both financial performance indicators calculated
from the above information AND the non-financial performance indicators provided.
NOTE: Clearly state any assumptions and show all workings clearly. Your answer should be structured
around the following main headings: turnover; cost of sales; gross profit; indirect expenses; net operating
profit. However, in discussing each of these areas you should also refer to the non-financial performance
indicators, where relevant. (20 marks)
S
M
A
C
Page 56 of 106
Transfer pricing
Q1. FP sells and repairs photocopiers. The company has operated for many years with two departments,
the Sales Department and the Service Department, but the departments had no autonomy. The company
is now thinking of restructuring so that the two departments will become profit centres.
The Sales Department
This department sells new photocopiers. The department sells 2,000 copiers per year. Included in the
selling price is 60 for a one year guarantee. All customers pay this fee. This means that during the first
year of ownership if the photocopier needs to be repaired then the repair costs are not charged to the
customer. On average 500 photocopiers per year need to be repaired under the guarantee. The repair
s
work is carried out by the Service Department who, under the proposed changes, would charge the Sales
Department for doing the repairs. It is estimated that on average the repairs will take 3 hours each and
that the charge by the Service Department will be 136,500 for the 500 repairs.
The Service Department
e
This department has two sources of work: the work needed to satisfy the guarantees for the Sales
e
Department and repair work for external customers. Customers are charged at full cost plus 40%. The
details of the budget for the next year for the Service Department revealed standard costs of:
Parts at cost
n
Labour 15 per hour
Variable overheads 10 per labour hour
Fixed overheads 22 per labour hour
The calculation of these standards is based on the estimated maximum market demand and includes the
A
expected 500 repairs for the Sales Department. The average cost of the parts needed for a repair is 54.
This means that the charge to the Sales Department for the repair work, including the 40% mark-up, will
be 136,500.
Proposed Change
a
It has now been suggested that FP should be structured so that the two departments become profit
centres and that the managers of the Departments are given autonomy. The individual salaries of the
r
managers would be linked to the profits of their respective departments.
i
Budgets have been produced for each department on the assumption that the Service
Department will repair 500 photocopiers for the Sales Department and that the transfer price for this work
will be calculated in the same way as the price charged to external customers.
a
However the manager of the Sales Department has now stated that he intends to have the repairs done
by another company, RS, because they have offered to carry out the work for a fixed fee of 180 per
repair and this is less than the price that the Sales Department would charge.
Z
Required:
(a) Calculate the individual profits of the Sales Department and the Service Department, and of FP as a
whole from the guarantee scheme if:
(i) The repairs are carried out by the Service Department and are charged at full cost plus 40%;
(ii) The repairs are carried out by the Service department and are charged at marginal cost;
(iii) The repairs are carried out by RS. (8 marks)
(b)
(i) Explain, with reasons, why a full cost plus transfer pricing model may not be appropriate for FP.
(3 marks)
(ii) Comment on other issues that the managers of FP should consider if they decide to allow RS to carry
out the repairs. (4 marks)
Page 57 of 106
Q2. CTD has two divisions FD and TM. FD is an iron foundry division which produces moldings that have
a limited external market and are also transferred to TM division. TM division uses the moldings to
produce a piece of agricultural equipment called the TX which is sold externally. Each TX requires one
molding. Both divisions produce only one type of product.
The performance of each Divisional Manager is evaluated individually on the basis of Residual Income (RI)
of his or her division. The companys average annual 12% cost of capital is used to calculate the finance
charges. If their own target Residual Income is achieved, each Divisional Manager is awarded a bonus
equal to 5% of his or her residual income. All bonuses are paid out of Head Office profits.
The following budgeted information is available for the following year:
TM Division FD Division
TX per unit Molding per unit
$ $
External Selling price 500 80
Variable production cost *366 40
Fixed production overheads 60 20_
Gross Profit 74 20
Variable selling and distribution cost 25 **4
S
Fixed administration overheads 25 4
Net profit 24 12
TM Division FD Division
Normal capacity (units) 15,000 20,000
M
Maximum production capacity 15,000 25,000
Sales to external customers (units) 15,000 5,000
Capital employed $15,00,000 $750,000
A
Target RI $105,000 $85,000
* The variable production cost of TX includes the cost of an FD molding.
** External sales only of the moldings incur a variable selling and distribution cost of $4 per unit.
FD division currently transfers 15000 moldings to TM division at a transfer price equal to the total
production cost plus 10%.
C
Fixed costs are absorbed on the basis of normal capacity.
Required:-
(a) Calculate the bonus each Divisional Manager receive under the current transfer pricing policy and
discuss any implications that the current performance evaluation system may have for each division and
for the company as a whole. (14 marks)
(b) Both divisional managers want to achieve their respective residual income targets. Based on the
budgeted figures, calculate:
(1) the maximum transfer price per unit that the divisional manager of TM would pay.
(2) the minimum transfer price per unit that the Divisional Manager of FD division would accept.
Page 58 of 106
Q3. Division A, which is a part of the ACF Group, manufactures only one type of product, a Bit, which it
sells to external customers and also to division C, another member of the group, ACF Groups policy is
that divisions have the freedom to set transfer prices and choose their suppliers.
The ACF Group uses residual income (RI) to assess divisional performance and each year it sets each
division a target RI. The groups cost of capital is 12% a year.
Division A
Budgeted information for the coming year is:
Maximum capacity 150,000 Bits
External sales 110,000 Bits
External selling price $35 per bit
Variable cost $22 per bit
s
Fixed cost $1,080,000
Capital employed $3,200,000
Targeted residual income $180,000
e
Division C
Division C has found two other companies willing to supply Bits:
X could supply at $28 per Bit, but only for annual orders in excess of 50000 Bits.
Z could supply at $33 per Bit for any quantity ordered.
Required:-
n e
(a) Division C provisionally request a quotation of 60000 Bits from Division A for the coming year.
(i) Calculate the transfer price per bit that division A should quote in order to meet its residual income
target. (6 marks)
(ii) Calculate the two prices division A would have to quote to division C, If It became group policy to
A
quote transfer prices based on opportunity costs. (4 marks)
Q4. Manuco ltd has been offered supplies of special ingredient Z at a transfer price of 15 per kg by
Helpo ltd which is part of the same group of companies. Helpo ltd processes and sells special ingredients
a
Z to customers external to the group at 15 per kg. Helpo ltd bases its transfer price on cost plus 25%
profit mark up. Total costs has been estimated as 75%variable and 25% fixed.
r
Required: -
i
Discuss the transfer price/prices at which Helpo ltd should offer to transfer special ingredient Z to Manuco
ltd in each of the following situations.
(a) Helpo ltd has an external market for all of its production of special ingredient Z at a selling price
a
of 15 per kg. Internal transfers to Manuco ltd would enable to save 1.50 per kg of variable
packing cost to be avoided.
(b) Conditions are as per (i) but Helpo ltd has spare capacity for 3000 kg os special ingredient Z for
Z
which no external market is available.
(c) Conditions are as per (ii) but Helpo ltd has an alternative use for some of its spare production
capacity. This alternative use is equivalent to 2,000 kg of apecial ingredient Z and would earn a
contribution of 6,000. (10 marks)
Page 59 of 106
Q5. Hammer is a large garden equipment supplier with retail stores throughout Toolland. Many of the
products it sells are bought in from outside suppliers but some are currently manufactured by Hammers
own manufacturing division Nail.
The prices (a transfer price) that Nail charges to the retail stores are set by head offi ce and have been the
subject of some discussion. The current policy is for Nail to calculate the total variable cost of production
and delivery and add 30% for profi t. Nail argues that all costs should be taken into consideration, offering
to reduce the mark-up on costs to 10% in this case. The retail stores are unhappy with the current pricing
policy arguing that it results in prices that are often higher than comparable products available on the
market.
Nail has provided the following information to enable a price comparison to be made of the two possible
pricing policies for one of its products.
Garden shears
Steel: the shears have 04kg of high quality steel in the final product. The manufacturing process loses 5%
of all steel put in. Steel costs $4,000 per tonne (1 tonne = 1,000kg)
Other materials: Other materials are bought in and have a list price of $3 per kg although Hammer
secures a 10% volume discount on all purchases. The shears require 01kg of these materials.
The labour time to produce shears is 025 hours per unit and labour costs $10 per hour.
S
Variable overheads are absorbed at the rate of 150% of labour rates and fi xed overheads are 80% of the
variable overheads.
Delivery is made by an outsourced distributor that charges Nail $050 per garden shear for delivery.
Required:
(a) Calculate the price that Nail would charge for the garden shears under the existing policy of
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variable cost plus 30%. (6 marks)
(b) Calculate the increase or decrease in price if the pricing policy switched to total cost plus 10%.
(4 marks)
(c) Discuss whether or not including fi xed costs in a transfer price is a sensible policy. (4 marks)
A
(d) Discuss whether the retail stores should be allowed to buy in from outside suppliers if the prices
are cheaper than those charged by Nail. (6 marks)
(20 marks)
Please read following articles from ACCA website by using following link
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http://www.accaglobal.com/students/acca/paperf5/syllabus_e
interpreting financial data

transfer pricing
End of Section E
Page 60 of 106
Section B
Decision Making
Relevant costing
Q1. TP Ltd is a small company that specialises in servicing computers. The company operates a standard
costing system and details of the standard cost of servicing a computer are shown below.
The figures were based on servicing 20,000 computers during the year.
Standard cost to service one computer:
s

Material
One unit of X 1000
One unit of Y
Labour (service engineers) 2 hours @ 15 per hour
Variable overheads 2 hours @ 750 per hour
Fixed overheads 2 hours @ 15 per hour
Total service cost
500
3000
1500
3000
9000
e e
n
Profit mark up 50% 4500
Service price per computer 1350
The majority of work that TP Ltd undertakes is based on three-year service contracts. However, PP Ltd, a
new local company, has asked TP Ltd to quote for an urgent stand-alone job of servicing 150 computers.
A
TP Ltd wants to win this order because it has some spare capacity, but knows that the standard price per
service is more than PP Ltd is willing to pay.
The accountant of TP Ltd has ascertained the following information:
Material X is regularly used. There is sufficient stock of Material X held, with a book value of 10 per
a
unit. The replacement cost of Material X is 11 per unit.
Material Y is regularly used. There are 100 units held in stock, with a book value of 5 per unit. The
r
replacement cost of Material Y is 550 per unit.
i
No additional engineers would be required to do this job. The service engineers are paid for a 35-
hour week. 70% of the time required to complete this job can be undertaken within normal working
hours; however, the remainder would have to be completed during overtime. Overtime is paid at time
a
plus a half.
There will be no additional fixed costs incurred by this job.
Required:
Z
TP Ltd is preparing a quote for the PP Ltd job based on relevant costing.
Page 61 of 106
Q2. A company manufactures and sells a wide range of products. The products are manufactured in
various locations and sold in a number of quite separate markets. The companys operations are
organised into five divisions which may supply each other as well as selling on the open market.
The following financial information is available concerning the company for the year just ended:
(000)
Sales 8,600
Production cost of sales 5,332
Gross profit 3,268
Other expenses 2,532
Net profit 736
An offer to purchase Division 5, which has been performing poorly, has been received by the company.
The gross profit percentage of sales, earned by Division 5 in the year, was half that earned by the
company as whole. Division 5 sales were 10% of total company sales. Of the production expenses incurred
by Division 5, fixed costs were 316,000. Other expenses (i.e. other than production expenses) incurred by
the division totalled 156,000, all of which can be regarded as fixed. These include 38,000 apportionment
of general company expenses which would not be affected by the decision concerning the possible sale of
Division 5.
S
In the year ahead, if Division 5 is not sold, fixed costs of the division would be expected to increase by 5%
and variable costs to remain at the same percentage of sales. Sales would be expected to increase by
10%.
If the division is sold, it is expected that some sales of other divisions would be lost. These would provide
a contribution to profits of 20 000 in the year ahead. Also, if the division is sold, the capital sum received
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could be invested so as to yield a return of 75,000 in the year ahead.
Required:
(a) Calculate whether it would be in the best interests of the company, based upon the expected situation
in the year ahead, to sell Division 5. (13 marks)
A
(b) Discuss other factors that you feel should influence the decision. (7 marks)
(c) Calculate the percentage increase in Division 5 sales required in the year ahead (compared with the
current year) for the financial viability of the two alternatives to be the same. (You are to assume that all
other factors in the above situation will remain as forecast for the year ahead.) (5 marks)
C
Q3. Bits and Pieces (B&P) operates a retail store selling spares and accessories for the car market. The
store has previously only opened for six days per week for the 50 working weeks in the year, but B&P is
now considering also opening on Sundays.
The sales of the business on Monday through to Saturday averages at $10,000 per day with average gross
profit of 70% earned.
B&P expects that the gross profit % earned on a Sunday will be 20 percentage points lower than the
average earned on the other days in the week. This is because they plan to offer substantial discounts and
promotions on a Sunday to attract customers. Given the price reduction, Sunday sales revenues are
expected to be 60% more than the average daily sales revenues for the other days. These Sunday sales
estimates are for new customers only, with no allowance being made for those customers that may
transfer from other days.
B&P buys all its goods from one supplier. This supplier gives a 5% discount on all purchases if annual
spend exceeds $1,000,000.
It has been agreed to pay time and a half to sales assistants that work on Sundays. The normal hourly rate
is $20 per hour. In total five sales assistants will be needed for the six hours that the store will be open on
a Sunday. They will also be able to take a half-day off (four hours) during the week. Staffing levels will be
allowed to reduce slightly during the week to avoid extra costs being incurred.
Page 62 of 106
The staff will have to be supervised by a manager, currently employed by the company and paid an
annual salary of $80,000. If he works on a Sunday he will take the equivalent time off during the week
when the assistant manager is available to cover for him at no extra cost to B&P. He will also be paid a
bonus of 1% of the extra sales generated on the Sunday project.
The store will have to be lit at a cost of $30 per hour and heated at a cost of $45 per hour. The heating
will come on two hours before the store opens in the 25 winter weeks to make sure it is warm enough
for customers to come in at opening time. The store is not heated in the other weeks
The rent of the store amounts to $420,000 per annum.
Required:
(a) Calculate whether the Sunday opening incremental revenue exceeds the incremental costs over
a year (ignore inventory movements) and on this basis reach a conclusion as to whether Sunday
s
opening is financially justifiable. (12 marks)
(b) Discuss whether the managers pay deal (time off and bonus) is likely to motivate him. (4 marks)
(c) Briefly discuss whether offering substantial price discounts and promotions on Sunday is a good
e
suggestion. (4 marks)
Q4. Relco plc is a construction company which has been asked to submiot a tender to build a new hotel
and size.
e
for a well-known national hotels group based in the UK. The special fiction for the hotel is as follows.
Six floors including ground floor reception and meeting rooms. Seventy bedrooms all of similar layout
n
A team of 100 construction workers are expected to be required to complete the project in the 18 months
allowed by the specification of the project.
These workers would be sourced as follows.
A
Newly recruited: 50 workers, annual wages: 25,000
Currently employed by Relco plc but not being used on any construction projects: 35 workers, annual
wages: 28,000 per annum.
Currently employed, by Relco plc on another project building a new shopping centre: 15 workers, annual
a
wages: 30000 per annum. These workers would be transferred to the hotel project but thiswill delay the
completion of shopping centre. Relco plc expects that this delay will cause them to have to suffer a
r
panelty of 1.5 million for going beyond the agreed completion date, as well as additional labour cost of
i
300,000.
Materials are expected to cost 2.1 million and will be purchased from the companys usual suppliers if
the tender is awarded to relco plc. Suppliers typically offer 10% discount trade discount to Relco plc.
a
Specialist equipment such as lifting gear, cement mixers and so on will be required.
Some equipment which is already owned by Relco plc and has a net book value of 500,000would be
used. The companys depreciation policy for equipment is 25% on a reducing balance method. This
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equipment is not expected to be required on other projects throught the next 18 months and beyond. It
couls now be sold 600,000. Other equipment will have to be hired at a hire cost of 30,000 per month.
The roof of the hotel included in the specification must be strong enough to support the weight of
helicopter as planning permission has already been given for a helipad on top of the building. The
materials required for the roof have not been included in the cost set out above. The only viable source
material is a company Helimats based in Germany who would charge around 600,000.
The exchange rate between the euro and sterling is currently 1= 1.40
The company adds 35% mark upo on relevant cost to arrive at the tender price.
Required: -
Estimate the tender price for the hotel with explanatory notes setting out the reasoning behind numbers
used.
Page 63 of 106
Q5. Brownton is a company that has in stock some type of material XY that cost 75,000 but that are now
obsolete and have a scrap value of only 21,000. other than selling the material as scrap, there are two
other options available.
Option 1:
Converting the obsolete material into specialized product which would require the following additional
work and material:
Material A 600 units
Material B 1,000 units
Direct labour
5000 hours of unskilled labour
5000 hours of semi skilled labour
5000 hours of highly skilled labour.
Extra selling and delivery expenses 27,000
Extra advertising 18,000
The conversion would produce 900 units of saleable product, and these could be sold for 400 per unit.
Material A is already in stock and is widely used within the firm. Although present stocks together with
orders already planned will be sufficient to facilitate normal activity, any additional material used by
adopting this alternative will necessitate such materials being replaced immediately. Material B is also in
S
stock, but it is unlikely that any additional supplies can be obtained for some considerable time because
of an industrial dispute. At the present time material B is normally used in the production od product Z,
which sells at 390 per unit and incur total variable cost (excluding material B) of 210 per unit. Each unit
of product Z uses 4 components of material B.
The details of material A and B are as follows
Material A Material B
M
Purchase price ( per unit) 100 10
Net realizable value 85 18
Market price (or replacement cost) 90 --
Option 2:
A
Adopting the obsolete materials for use as an substitute for sub assembly that is regularly used within the
firm. Details of the extra work and material required are as follows.
Material C 1,000 units
Direct labour
4000 unskilled hours
C
1000 hours of semi skilled
4000 hours of highly skilled labour
1200 units of sub-assembly are regularly used per quarter at cost of 900 per unit. The adaption of
material XY would reduce the quantity of the sub assembly. Purchased from the outside supplier to 900
units per quarter. However since the volume purchased would be reduced some discount would be lost
and the price of those purchased from outside would increase to 950 per unit for that quarter.
Material C is not available externally, but is manufactured by Brown ltd. The 1000 units required would be
available from stock but would provide as extra production. The standard cost per unit of material C would
be as follows

Direct labour 36
Raw material 13
Variable overheads 06
Fixed overheads 18
73
Page 64 of 106
Other information
Wage rate and overhead recovery rates are as follows
Variable overheads 1 per labour hour
Fixed overheads 3 per labour hour
Unskilled labour 6 per labour hour
Semi skilled labour 8 per labour hour
Highly skilled labour 10 per labour hour
The unskilled labour is supplied on casual basis and sufficient labour can be acquired to exatly meet the
production requirement. Semi skilled labour is part of permanent labour force. Company has currently
excess supply of semi skilled labour. Highly skilled labour is in short supply and cannot be increased
significantly in short term; this labour is presently engaged in in the production of product L, which
requires 4 hours of skilled labour. The contribution (sales less direct labour, material and other variable
costs) from the sale of one unit of product L is 24 .
Required: -
value
Profit maximisation in case of limiting factor

e s
Advise management whether XY should be used for option 1, option 2 or sold at its current realizable
e
Q6. GHK manufactures four products from different combinations of the same direct materials and direct
labour. An extract from the flexible budgets for next quarter for each of these products is as follows:
n
A
Notes
r a
1.
a i
Material A was purchased some time ago at a cost of $5 per kg. There are 5,000 kgs in inventory.
The costs shown in the flexible budget are based on this historical cost. The material is in regular
use and currently has a replacement cost of $7 per kg.
2. Material B is purchased as required; its expected cost is $10 per kg. The costs shown in the flexible
budget are based on this expected cost.
3. Direct labour costs are based on an hourly rate of $10 per hour. Employees work the number of
Z
hours necessary to meet production requirements.
4. Overhead costs of each product include a specific fixed cost of $1,000 per quarter which would be
avoided if the product was to be discontinued. Other fixed overhead costs are apportioned
between the products but are not affected by the mix of products manufactured.
GHK has been advised by the only supplier of material B that the quantity of material B that will be
available during the next quarter will be limited to 5,000 kgs. Accordingly the company is being forced to
reconsider its production plan for the next quarter. GHK has already entered into contracts to supply one
of its major customers with the following:
500 units of product G
1,600 units of product H
800 units of product J
Page 65 of 106
400 units of product K
Apart from this, the demand expected from other customers is expected to be
3,600 units of product G
3,000 units of product H
3,000 units of product J
4,000 units of product K
The major customer will not accept partial delivery of the contract and if the contract with this major
customer is not completed in full, then GHK will have to pay a financial penalty of $5,000.
Required:
(a) For each of the four products, calculate the relevant contribution per $ of material B for the next
quarter. (12 marks)
(b) Calculate the relevant contribution to sales ratios for each of the four products. (2 marks)
(c) Determine optimum production plan the amount of financial penalty at which GHK would be
indifferent between meeting the contract or paying the penalty. (6 marks)
Q7. The managers of Albion plc are reviewing the operations of the company with a view to making
S
operational decisions for the next month. Details of some of the products manufactured by the company
are given below.
Product AR2 GL3 HT4 XY5
Selling price (/unit) 2100 2850 2730
Material R2 (kg/unit) 20 30 30
Material R3 (kg/unit) 20 22 16 30
M
Direct labour (hours/unit) 06 12 15 17
Variable production overheads (/unit) 110 130 110 140
Fixed production overheads (/unit) 150 160 170 140
Expected demand for next month (units) 950 1,000 900
A
Products AR2, GL3 and HT4 are sold to customers of Albion plc, while Product XY5 is a component that is
used in the manufacture of other products. Albion plc manufactures a wide range of products in addition
to those detailed above.
Material R2, which is not used in any other of Albions products, is expected to be in short supply in the
C
next month because of industrial action at a major producer of the material. Albion plc has just received a
delivery of 5,500 kg of Material R2 and this is expected to be the amount held in stock at the start of the
next month. The company does not expect to be able to obtain further supplies of Material R2 unless it
pays a premium price. The normal market price is 250 per kg.
Material R3 is available at a price of 200 per kg and Albion plc does not expect any problems in securing
supplies of this material. Direct labour is paid at a rate of 400 per hour.
Folam Limited has recently approached Albion plc with an offer to supply a substitute for Product XY5 at a
price of 1020 per unit. Albion plc would need to pay an annual fee of 50,000 for the right to use this
patented substitute.
Required:
(a) Calculate contribution margin per unit of AR2, GL3 and HT4
(b) Determine the optimum production schedule for Products AR2, GL3 and HT4 for the next
month, on the assumption that additional supplies of Material R2 are not purchased.
(c) If Albion plc decides to purchase further supplies of Material R2 to meet demand for Products
AR2, GL3 and HT4, what should be the maximum price per kg that the company is prepared to pay?
Page 66 of 106
(d) Discuss whether Albion plc should manufacture Product XY5 or buy the substitute offered by
Folam Limited. Your answer must be supported by appropriate calculations.
Further processing
Q8. Z is one of a number of companies that produce three products for an external market. The three
products, R, S and T may be bought or sold in this market.
The common process account of Z for March 2007 is shown below:
Kg $ Kg $
Inputs:
Material A 1,000 3,500 Normal loss 500 0
s
Material B 2,000 2,000 Outputs:
Material C 1,500 3,000 Product R 800 3,500
Direct labour 6,000 Product S 2,000 8,750
e
Variable overhead 2,000 Product T 1,200 5,250
Fixed cost 1,000
Totals 4,500 17,500 4,500 17,500
e
Z can sell products R, S or T after this common process or they can be individually further processed and
sold as RZ, SZ and TZ respectively. The market prices for the products at the intermediate stage and after
further processing are:
n
Market prices per kg:
$
R 300
A
S 500
T 350
RZ 600
SZ 575
TZ 675
a
The specific costs of the three individual further processes are:
Process R to RZ variable cost of $140 per kg, no fixed costs
Required:
r
Process S to SZ variable cost of $090 per kg, no fixed costs and further process loss of 10%
i
Process T to TZ variable cost of $100 per kg, fixed cost of $600 per month
(a) Produce calculations to determine whether any of the intermediate products should be further
a
processed before being sold. Clearly state your recommendations together with any relevant assumptions
that you have made. (3 marks)
(b) Produce calculations to assess the viability of the common process:
Z
(i) assuming that there is an external market for products R,S and T; and
(ii) assuming that there is not an external market for products R,S and T.
State clearly your recommendations. (7 marks)
Page 67 of 106
Q9. Furnival has distillation plant that produces three joint products P, Q, R in the proportion of 10:5:5.
After the split-off point the products can be sold for Industrial use or they can be taken ti mixing plant for
blending and refining. The later procedures is normally followed.
For a typical week, in which all the output is processed in the mixing plant, the following profit and loss
account can be prepared:
Product P Product Q Product R
Sales volume 1,000 gallon 500 gallon 500 gallon
Price per gallon 12.50 20 10
Sales revenue 12500 10000 5000
Joint process cost
(apportioned cost using volume) 5000 2500 2500
Mixing plant cost
Process cost 3000 3000 3000
Other separable cost 2000 500 500
Profit/loss 2500 4000 1000
The joint process costs are 25% fixed and 75% variable, whereas mixing plant costs are 10% fixed and 90%
variable and all other separable costs are variable
S
If the product has been sold at the split-off point the price per gallon would have been
Product P Product Q Product R
5.00 6.00 1.50
There are only 45 hours of labour time available per week in the mixing plant. Typically 30 hours are taken
up with the processing of Product P Q and R (10 hours per product line) and 15 hours are used for the
M
other work that generates (on average) a profit of 200 per hour after being charged with a proportionate
share of plants costs (including fixed costs). The manager of the mixing plant considers that he could sell
all the plants processing time externally at a price that would provide this rate of profit.
It has been suggested that
A
i. Since product R regularly makes a loss, it should be sold at split-off point
ii. It might be possible to charge the mix of the products achieved in the distillation plant. It is
possible to change the output proportions to 7:8:5 at a cost of 1 for each additional gallon of Q
produced by distillation plant.
Required: -
C
Compare costs and benefits of each of the above proposals. Use your analysis to suggest any
improvements that seem profitable and set out the weekly profit and loss account for the improved plan,
in a manner which you consider will assist the management with further problem of this type. (20 marks)
Page 68 of 106
Q10. An engineering company manufactures a number of products and components, using a team of
highly skilled workers and a variety of different metals.
The current supplier has announced that the amount of M1, one of the materials it currently supplies, will
be limited to 1,000 square metres in total for the next three-month period because there will be
insufficient M1 to satisfy demand.
The only items manufactured using M1 and their production costs and selling prices (where applicable)
are shown below:
e s
M1 continuing to be available at a price of $20 per square metre.
** Fixed overhead is absorbed on the basis of direct labour cost. e
* Material M1 is expected to be limited in supply during the next three months. These costs are based on
n
Products P4 and P6 are sold externally. Components C3 and C5 are used in other products made by the
company. These other products do not require any further amounts of material M1.
A
The estimated total demand for these products and components during the next three months is as
follows:
P4 2,000 units
P6 1,500 units
a
C3 500 units
C5 1,000 units
r
Components C3 and C5 are essential components. They would have to be bought in if they could not be
i
made internally. They can be purchased from external suppliers for $75 and $95 per unit respectively. The
bought in components are of the same quality as those manufactured by the company. The products they
are used in have sufficient margins to remain financially worthwhile if C3 and C5 are bought in at these
a
prices. P2
Required:
(a) Prepare calculations to show the most profitable course of action for the company for the next three
Z
months, assuming that there are no other suppliers of material M1, and advise the company on THREE
other factors that it should consider before making its decision. (14 marks)
Q11. Sniff Co manufactures and sells its standard perfume by blending a secret formula of aromatic oils
with diluted alcohol. The oils are produced by another company following a lengthy process and are very
expensive. The standard perfume is highly branded and successfully sold at a price of $3998 per 100
millilitres (ml).
Sniff Co is considering processing some of the perfume further by adding a hormone to appeal to
members of the opposite sex. The hormone to be added will be different for the male and female
perfumes. Adding hormones to perfumes is not universally accepted as a good idea as some people have
health concerns. On the other hand, market research carried out suggests that a premium could be
charged for perfume that can promise the attraction of a suitor. The market research has cost $3,000.
Page 69 of 106
Data has been prepared for the costs and revenues expected for the following month (a test month)
assuming that a part of the companys output will be further processed by adding the hormones.
The output selected for further processing is 1,000 litres, about a tenth of the companys normal monthly
output. Of this, 99% is made up of diluted alcohol which costs $20 per litre. The rest is a blend of aromatic
oils costing $18,000 per litre. The labour required to produce 1,000 litres of the basic perfume before any
further processing is 2,000 hours at a cost of $15 per hour.
Of the output selected for further processing, 200 litres (20%) will be for male customers and 2 litres of
hormone costing $7,750 per litre will then be added. The remaining 800 litres (80%) will be for female
customers and 8 litres of hormone will be added, costing $12,000 per litre. In both cases the adding of the
hormone adds to the overall volume of the product as there is no resulting processing loss.
Sniff Co has sufficient existing machinery to carry out the test processing.
The new processes will be supervised by one of the more experienced supervisors currently employed by
Sniff Co.
His current annual salary is $35,000 and it is expected that he will spend 10% of his time working on the
hormone adding process during the test month. This will be split evenly between the male and female
versions of the product.
Extra labour will be required to further process the perfume, with an extra 500 hours for the male version
S
and 700 extra hours for the female version of the hormone-added product. Labour is currently fully
employed, making the standard product. New labour with the required skills will not be available at short
notice.
Sniff Co allocates fixed overhead at the rate of $25 per labour hour to all products for the purposes of
reporting profits. The sales prices that could be achieved as a one-off monthly promotion are:
M
Male version: $7500 per 100 ml
Female version: $5950 per 100 ml
Required:
(a) Outline the financial and other factors that Sniff Co should consider when making a further
A
processing decision. (4 marks)
(b) Evaluate whether Sniff Co should experiment with the hormone adding process using the data
provided. Provide a separate assessment and conclusion for the male and the female versions of
the product. (15 marks)
(c) Calculate the selling price per 100 ml for the female version of the product that would ensure
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further processing would break even in the test month. (2 marks)
(d) Sniff Co is considering outsourcing the production of the standard perfume. Outline the main
factors it should consider before making such a decision. (4 marks)
Page 70 of 106
Risk and Uncertainty
Q1. Envico Ltd, another subsidiary of the KCB Group, is well established and provides seminars on various
aspects of current and recently announced changes in employment legislation. Envico Ltd has decided to
enter into a one-year renewable contract with Mieras Business Associates, which owns large premises that
are suitable for holding educational seminars in each of eight cities. Envico Ltd has had similar dealings
with Mieras Business Associates during recent years.
Mieras Business Associates has offered a choice of four different contracts, each of which relates to
seminar rooms of differing sizes. These are known as room types A, B, C and D, which are capable of
accommodating 100, 200, 300 and 400 delegates respectively.
Envico Ltd will charge an all-inclusive fee of 80 per delegate at every seminar throughout the year. The
cost incurred by Envico Ltd varies according to room type, as shown in the following table:
Room type
A
B
C
No of attendees
100
200
300
Cost per seminar ()
6,000
10,800
14,400
e s
e
D 400 16,000
Envico must decide in advance of the forthcoming year which size of conference room to contract for. It is
not possible to contract for a different size conference room in different cities, i.e. only one size of room
n
can be the subject of the contract with Mieras Business Associates.
Due to the rapid growth in interest regarding environmental issues and corporate social responsibility,
and the large amount of forthcoming legislative changes, Envico Ltd has decided to hold one seminar in
A
every week of the year in each city. Sometimes a regional government representative will attend and
speak at such seminars.
On other occasions a national government representative will attend and speak at such seminars. The rest
of the time the speakers at seminars are representatives from within Envico Ltd.
Envico has estimated the following frequency regarding seminars to be held during the forthcoming year:
a
Category of speaker: %
Envico representative 20
r
Regional government representative 50
i
National government representative 30
Market research has indicated that where a national government representative is in attendance, Envico
Ltd can be reasonably assured of selling 400 seminar places and where a regional government
a
representative is in attendance 200 seminar places can be sold. Envico Ltd expects to sell only 100 seminar
places when there is no attendance by a government representative.
Required:
Z
(i) Advise Envico Ltd on the size of seminar room that should be contracted from Mieras Business
Associates, using the criterion of expected value. Your answer should show the expected annual
contribution from each decision option. (9 marks)
(ii) Determine whether your decision in (b)(i) would change if you were to use the Maximin and
Minimax regret decision criteria. Your answer should be supported by relevant workings.
(6 marks)
Page 71 of 106
Q2. Healthfoods Ltd (HFL) is a well-established company which markets fruit and vegetables under their
Good Health brand name at each of its 6 outlets in the country of Ateland. During recent years HFL has
marketed organically grown fruit and vegetables. The directors are now planning to market organic
mushrooms which have a unique eating quality and will be the most nutritious mushrooms available on
the market.
The finance director has collated the following information regarding the proposed introduction and sale
of organic mushrooms within Ateland:
(1) HFL will purchase the organic mushrooms from Orgmush Ltd (OML) and sell them at each of its 6
outlets within Ateland. Sales volumes of organic mushrooms are expected to be at the same level at each
outlet.
(2) OML, which is the only grower of this particular type of organic mushroom within Ateland, has offered
HFL a choice of four different contracts in respect of the forthcoming year. OML has the capacity to
produce 360,000 kilograms of organic mushrooms for each of the 6 outlets.
The cost incurred by HFL in respect of organic mushrooms will vary according to contract size, as shown in
the following table:
Contract Number of kilograms Cost per kilogram ()
A 160,000 445
S
B 240,000 370
C 280,000 355
D 360,000 335
Note: The same contract type must be chosen in respect of each outlet.
(3) HFL will charge 550 per kilogram for all sales of organic mushrooms.
M
(4) Any unsold produce will be sold to the Animal Farm Group for 025 per kilogram.
(5) HFL must decide in advance of the forthcoming year which size of contract to enter.
(6) HFL uses acclaimed dieticians, international athletes or international film stars to promote its products
via television advertisements and has estimated the following probability distribution of advertisements to
A
be held during the forthcoming year:
Category of advertisement: %
Acclaimed dietician 20
International athlete 40
International film star 40
C
Market research has indicated that where an acclaimed dietician appears in an advertisement, HFL can be
reasonably assured of selling 160,000 kilograms of mushrooms per outlet and where an international
athlete appears in an advertisement then 234,000 kilograms of mushrooms per outlet will be sold. HFL
expects to sell 360,000 kilograms of mushrooms per outlet when an international film star appears in an
advertisement.
Required:
(a) Using expected values, advise HFL regarding which contract should be entered into with OML.
Your answer should show the expected annual contribution from each contract. (12 marks)
(b) Determine whether your decision in (a) would change if you were to use each of the Maximin
and Minimax regret decision criteria. (6 marks)
(c) Briefly discuss why the directors of HFL might choose contract D irrespective of whether or not
contract D would have been selected using expected values as per part (a). (2 marks)
Page 72 of 106
Q3. Shifters Haulage (SH) is considering changing some of the vans it uses to transport crates for
customers. The new vans come in three sizes; small, medium and large. SH is unsure about which type to
buy. The capacity is 100 crates for the small van, 150 for the medium van and 200 for the large van.
Demand for crates varies and can be either 120 or 190 crates per period, with the probability of the higher
demand figure being 06.
The sale price per crate is $10 and the variable cost $4 per crate for all van sizes subject to the fact that if
the capacity of the van is greater than the demand for crates in a period then the variable cost will be
lower by 10% to allow for the fact that the vans will be partly empty when transporting crates. SH is
concerned that if the demand for crates exceeds the capacity of the vans then customers will have to be
turned away. SH estimates that in this case goodwill of $100 would be charged against profits per period
to allow for lost future sales regardless of the number of customers that are turned away.
s
Depreciation charged would be $200 per period for the small, $300 for the medium and $400 for the large
van.
SH has in the past been very aggressive in its decision-making, pressing ahead with rapid growth
e
strategies. However, its managers have recently grown more cautious as the business has become more
competitive.
Required:
sometimes used to make decisions in uncertain situations.
e
(a) Explain the principles behind the maximax, maximin and expected value criteria that are
(4 marks)
n
(b) Prepare a profits table showing the SIX possible profit figures per period. (9 marks)
(c) Using your profit table from (b) above discuss which type of van SH should buy taking into
consideration the possible risk attitudes of the managers. (6 marks)
(d) Describe THREE methods other than those mentioned in (a) above, which businesses can use to
A
analyse and assess the risk that exists in its decision-making (6 marks)
Q4. A ticket agent has an arrangement with a concert hall that holds concerts on 60 nights a year
whereby he receives discounts as follows per concert:
a
For purchase of He receives a discount of
200 tickets 20%
r
300 tickets 25%
i
400 tickets 30%
500 tickets or more 40%
Purchases must be in full hundreds. The average price per ticket is $30.
a
He must decide in advance each year the number of tickets he will purchase. If he has any tickets unsold
by the afternoon of the concert he must return it to the box office. If the box office sells any of these he
receives 60% of their price.
Z
His sales records over a few years show that for a concert with extremely popular artistes he can be
confident of selling 500 tickets, for one with lesser known artistes 350 tickets, and for one with relatively
unknown artistes 200 tickets.
His records show that 10% of the tickets he returns are sold by the box office. (Note: these are in addition
to any sales made by the ticket agent).
His administration costs incurred in selling tickets are the same per concert irrespective of the popularity
of the artistes.
There are two possible scenarios in which his sales records can be viewed:
Scenario 1: that, on average, he can expect concerts with less known artistes.
Page 73 of 106
Scenario 2: that the frequency of concerts will be:
%
With popular artistes 45
With lesser known artistes 30
With unknown artistes 25
100
Required:
a) Calculate separately for each of Scenario 1 and 2:
The expected demand for tickets per concert
The level of his purchases of tickets per concert that will give him the largest profit over a long
period of time
The profit per concert that this level of purchases of tickets will yield. (16 marks)
b) Calculate for Scenario 2 only the number of tickets the agent should buy, based on the following
criteria:
Maximin
Maximax
S
Minimax regret (5 marks)
c) Advise the ticket agent (4 marks)
M
A
C
Page 74 of 106
Linear Programming
Q1. A profit-seeking firm has two constraints: labour, limited to 16,000 hours, and materials, limited to
15,000kg. The firm manufactures and sells two products, X and Y. To make X, the firm uses 3kg of material
and four hours of labour, whereas to make Y, the firm uses 5kg of material and four hours of labour. The
contributions made by each product are $30 for X and $40 for Y. The cost of materials is normally $8 per
kg and the labour rate is $10 per hour.
Required: -
By using linear programming, calculate production plan which will maximize profit.
s
Q2. Following details are given about a manufacturing company
Assembly Testing
Department Department
Reliance star
Reliance super star
2.0 hours
4.0 hours
1.5 hours
1.0 hours
e e
The assembly department has maximum of 12,000 hours available per month. The testing department has
a maximum of 6,000 hours available per month. Because of limited availability of component parts for the
reliance star batteries, the maximum demand of reliance star batteries per month is 3,500.
n
Summerised financial data about each product are given as follows
Reliance star Reliance super star
Selling price 2,200 3,500
Direct material 700 1100
hour.
Required: -
A
Variable assembly department costs are 300 per hour. Variable testing department costs are 200 per
What is the optimal mix of the reliance star and reliance super star product per month in order to
a
maximise profit.
r
Shadow price
i
Shadow price of a product is increase in value (usually extra contribution) which would be created by
having available one additional unit of limiting factor.
It therefore represents maximum premium that the firm would be willing to pay for one extra unit of
a
constraint.
If extra cost of any proposal is less than the shadow price then it is affordable by the business and
should accept the offer.
Z
Non-critical constraints (or slack) will have zero shadow price as they are already available
Page 75 of 106
Q3. DFG manufactures two products from different combinations of the same resources. Unit selling
prices and unit cost details for each product are as follows:
Product
D G
/unit /unit
Direct material A (5 per kg) 20 10
Direct material B (3 per kg) 12 24
Skilled labour (7 per hour) 28 21
Variable overhead (2/machine hour) 14 18
Fixed overhead* 28 36
Profit 13 11
*Fixed overhead is absorbed using absorption rate per machine hour. It is an unavoidable central
overhead cost that is not affected by the mix or volume of products produced.
The maximum weekly demand for products D and G is 400 units and 450 units respectively and this is the
normal weekly production volume achieved by DFG. However, for the next four weeks the achievable
production level will be reduced due to a shortage of available resources. The resources that are expected
S
to be available are as follows:
Direct material A 1,800kg
Direct material B 3,500kg
Skilled labour 2,500 hours
Machine time 6,500 machine hours
M
Required:
Using graphical linear programming identify the weekly production schedule for products D and G that
maximises the profits of DFG during the next four weeks.
A
Q4. Higgins Co (HC) manufactures and sells pool cues and snooker cues. The cues both use the same type
of good quality wood (ash) which can be difficult to source in sufficient quantity. The supply of ash is
restricted to 5,400 kg per period. Ash costs $40 per kg.
The cues are made by skilled craftsmen (highly skilled labour) who are well known for their workmanship.
The skilled craftsmen take years to train and are difficult to recruit. HCs craftsmen are generally only able
C
to work for 12,000 hours in a period. The craftsmen are paid $18 per hour.
HC sells the cues to a large market. Demand for the cues is strong, and in any period, up to 15,000 pool
cues and 12,000 snooker cues could be sold. The selling price for pool cues is $41 and the selling price for
snooker cues is $69.
Manufacturing details for the two products are as follows:
Pool cues Snooker cues
Craftsmen time per cue 05 hours 075 hours
Ash per cue 270 g 270 g
Other variable costs per cue $120 $470
HC does not keep inventory.
Required:
(a) Calculate the contribution earned from each cue. (2 marks)
(b) Determine the optimal production plan for a typical period assuming that HC is seeking to
maximise the contribution earned. You should use a linear programming graph (using the graph
paper provided), identify the feasible region and the optimal point and accurately calculate the
maximum contribution that could be earned using whichever equations you need. (12 marks)
Page 76 of 106
Some of the craftsmen have offered to work overtime, provided that they are paid double time for the
extra hours over the contracted 12,000 hours. HC has estimated that up to 1,200 hours per period could
be gained in this way.
Required:
(c) Explain the meaning of a shadow price (dual price) and calculate the shadow price of both the
labour (craftsmen) and the materials (ash). (5 marks)
(d) Advise HC whether to accept the craftsmens initial offer of working overtime, discussing the
rate of pay requested, the quantity of hours and one other factor that HC should consider.
(6 marks)
The Cosmetic Co is a company producing a variety of cosmetic creams and lotions. The creams and
s
lotions are sold to a variety of retailers at a price of $2320 for each jar of face cream and $1680 for each
bottle of body lotion. Each of the products has a variety of ingredients, with the key ones being silk
powder, silk amino acids and aloe vera. Six months ago, silk worms were attacked by disease causing a
e
huge reduction in the availability of silk powder and silk amino acids. The Cosmetic Co had to dramatically
reduce production and make part of its workforce, which it had trained over a number of years,
redundant.
e
The company now wants to increase production again by ensuring that it uses the limited ingredients
available to maximise profits by selling the optimum mix of creams and lotions. Due to the redundancies
n
made earlier in the year, supply of skilled labour is now limited in the short-term to 160 hours (9,600
minutes) per week, although unskilled labour is unlimited. The purchasing manager is confident that they
can obtain 5,000 grams of silk powder and 1,600 grams of silk amino acids per week. All other ingredients
are unlimited. The following information is available for the two products:
A
Cream Lotion
Materials required:
-- silk powder (at $220 per gram) 3 grams 2 grams
silk amino acids (at $080 per gram) 1 gram 05 grams
a
aloe vera (at $140 per gram) 4 grams 2 grams
Labour required:
r
-- skilled ($12 per hour) 4 minutes 5 minutes
i
unskilled (at $8 per hour) 3 minutes 15 minutes
Each jar of cream sold generates a contribution of $9 per unit, whilst each bottle of lotion generates a
contribution of $8 per unit. The maximum demand for lotions is 2,000 bottles per week, although demand
a
for creams is unlimited. Fixed costs total $1,800 per week. The company does not keep inventory although
if a product is partially complete at the end of one week, its production will be completed in the following
week.
Z
Required:
(a) On the graph paper provided, use linear programming to calculate the optimum number of
each product that the Cosmetic Co should make per week, assuming that it wishes to maximise
contribution. Calculate the total contribution per week for the new production plan. All workings
MUST be rounded to 2 decimal places. (14 marks)
(b) Calculate the shadow price for silk powder and the slack for silk amino acids. All workings
MUST be rounded to 2 decimal places. (6 marks)
Read examiner article on linear programming

http://www.accaglobal.com/students/acca/paperf5/syllabus_b
Page 77 of 106
Section C (Budgeting)
Learning Curve
Conditions for the learning effect to apply:
The activity is labour intensive
A repetitive process for each unit
Low turnover of labour
Early stages of production
No prolonged breaks in production
Applications of the learning effect:
Pricing decisions prices will be set too high if based on the costs of making the first few units
Work scheduling less labour per unit will be required as more units are made
Limiting factor decisions
Standard setting
S
Budgeting
Cessation of the learning effect (steady state):
Machine efficiency restricts further improvements
Machines have reached the limits of safe running speeds
go slow agreements.
M
1. You are the management accountant of a new small company that has developed a new product
using a labour intensive production process. You have recently completed the budgets for the
company for next year and, before they are approved by the Board of Directors, you have been
asked to explain your calculation of the labour time required for the budgeted output. In your
A
calculations, you anticipated that the time taken for the first unit would be 40 minutes and that
75% learning curve would apply for the first 30 units.
Required:
(a) Explain the concept of the learning curve and why it may be relevant to the above company.
C
(b) Calculate the expected time for the 6th unit of output.
(c) Discuss the implications of the learning curve for a company adopting a penetration pricing
policy.
2. A manufacturing company has developed a new product. The time taken to manufacture the first
unit was 180 minutes. It is expected that a 90% learning curve will apply for the first three months
of production and that by the end of that period the total number of units produced will have
reached 1,024. It is then expected that the time taken for each subsequent unit will be the same
as the time taken for the 1,024th unit.
Required:
(i) Calculate the expected time taken for the 8th unit.
(ii) Explain two reasons why the time taken for the 1025th unit may be more than expected.
3. A company is preparing a quotation for a new product. The time taken for the first unit of the
product was 30 minutes and the company expects an 85% learning curve. The quotation is to be
based on the time taken for the final unit within the learning period which is expected to end
after the company has produced 200 units.
Page 78 of 106
Required
Calculate the time per unit to be used for the quotation.
4. A company is planning to launch a new product. It has already carried out market research at a
cost of $50,000 and as a result has discovered that the market price for the product should be $50
per unit. The company estimates that 80,000 units of the product could be sold at this price
before one of the companys competitors enters the market with a superior product. At this time
any unsold units of the companys product would be of no value.
The company has estimated the costs of the initial batch of the product as follows:
$000
Direct materials 200
s
Direct labour ($10 per hour) 250
Other direct costs 100
Production was planned to occur in batches of 10,000 units and it was expected that an 80%
e
learning curve would apply to the direct labour until the fourth batch was complete. Thereafter
the direct labour cost per batch was expected to be constant. No changes to the direct labour
rate per hour were expected.
e
The company introduced the product at the price stated above, with production occurring in
batches of 10,000 units. Direct labour was paid using the expected hourly rate of $10 and the
n
company is now reviewing the profitability of the product. The following schedule shows the
actual direct labour cost recorded:
Cumulative number of batches Actual cumulative direct labour cost
$000
A
1 280
2 476
4 809
8 1,376
a
Required:
(i) Calculate the revised expected cumulative direct labour costs for the four levels of output given
r
the actual cost of $280,000 for the first batch.
i
(ii) Calculate the actual learning rate exhibited at each level of output.
5. Henry Company (HC) provides skilled labour to the building trade. They have recently been asked
a
by a builder to bid for a kitchen fitting contract for a new development of 600 identical
apartments. HC has not worked for this builder before. Cost information for the new contract is as
follows:
Z
Labour for the contract is available. HC expects that the first kitchen will take 24 man-hours to fit
but thereafter the time taken will be subject to a 95% learning rate. After 200 kitchens are fitted
the learning rate will stop and the time taken for the 200th kitchen will be the time taken for all
the remaining kitchens. Labour costs $15 per hour.
Overheads are absorbed on a labour hour basis. HC has collected overhead information for the
last four months and this is shown below:
Hours worked Overhead cost $
Month 1 9,300 115,000
Month 2 9,200 113,600
Month 3 9,400 116,000
Month 4 9,600 116,800
HC normally works around 120,000 labour hours in a year.
Page 79 of 106
HC uses the high low method to analyse overheads.
Required:
(a) Describe FIVE factors, other than the cost of labour and overheads mentioned above,
that HC should take into consideration in calculating its bid. (10 marks)
(b) Calculate the total cost including all overheads for HC that it can use as a basis of the
bid for the new apartment contract. (13 marks)
(c) If the second kitchen alone is expected to take 216 man-hours to fit demonstrate how
the learning rate of 95% has been calculated. (2 marks)
6. BFG Limited is investigating the financial viability of a new product the S-pro. The S-pro is a short-
life product for which a market has been identified at an agreed design specification. The product
will only have a life of 12 months.
The following estimated information is available in respect of S-pro:
1. Sales should be 120,000 in the year in batches of 100 units. An average selling price of $1,050
per batch of 100 units is expected. All sales are for cash.
2. An 80% learning curve will apply for the first 700 batches after which a steady state production
S
time will apply, with the labour time per batch after the first 700 batches being equal to the time
for the 700th batch. The cost of the first batch was measured at $2,500. This was for 500 hours at
$5 per hour.
3. Variable overhead is estimated at $2 per labour hour.
4. Direct material will be $500 per batch of S-pro for the first 200 batches produced. The second
200 batches will cost 90% of the cost per batch of the first 200 batches. All batches from then on
M
will cost 90% of the batch cost for the second 200 batches. All purchases are made for cash
5. S-pro will require additional space to be rented. These directly attributable fixed costs will be
$15,000 per month.
A target net cash flow of $130,000 is required in order for this project to be acceptable.
A
Required:
(a) Prepare calculations to show whether product S-pro will provide target net cash flow.
(b) Calculate what length of time then second batch will take if the actual rate of learning
is:
C
(i) 80%; (ii) 90%.
Explain which rate shows the faster learning.
Page 80 of 106
Time series analysis
Q1. Following are details given about sales and its trend of a company
sales seasonal
volume Trend variation
week 1 day 1 8500
day 2 8600
day 3 8780 43150 8630
day 4 8650 43200 8640
s
day 5 8620 43230 8646
week2 day 1 8550 43300 8660
day 2 8630 43370 8674
e
day 3 8850 43430 8686
day 4 8720 43490 8698
day 5 8680 43650 8730
week 3 day 1
day 2
day 3
day 4
day 5
8610
8790
8920
8800
8740
43720
43800
43860
8744
8760
8772
n e
A
Required:-
Calculate
i. seasonal variation
ii. average growth per day
Year 1 Quarter 1
Sales
9000
r a Trend Seasonal variation
Quarter 2
a
Quarter 3
Quarter 4
i 6200
5100
11000
7825
8275
8050
8425
Year 2
Z Quarter 1
Quarter 2
Quarter 3
10800
7400
6000
8575
8800
9175
8687.5
8987.5
9243.75
9312.5
Quarter 4 12500 9425
9537.5
Page 81 of 106
Year 3 Quarter 1 11350 9625
9712.5
Quarter 2 8300 9850
9987.5
Quarter 3 6700
Quarter 4 13600
Required: -
i. Calculate average growth per quarter and average seasonal variation by using above data.
ii. Calculate sales volume of 4th quarter of year 5 and 2nd quarter of year 6
Q3. It is mid-June and the new managing director of Storrs plc is reviewing sales forecasts for Quarter 3 of
2003, which begins on 1 July, and for Quarter 4. The company manufactures garden furniture and
experiences seasonal variations in sales, which has made forecasting difficult in the past. Sales for the last
two calendar years were as follows:
S
Year Quarter 1 Quarter 2 Quarter 3 Quarter 4
2001 2,700,000 3,500,000 3,400,000 3,000,000
2002 3,100,000 3,900,000 3,600,000 3,400,000
Sales in Quarter 1 of 2003 were 3,600,000. There is two weeks to go until the end of Quarter 2 and the
managing director of Storrs plc is confident that it will achieve sales of 4,400,000 in this quarter.
The existing sales forecasts for the two remaining quarters of the year were made by the sales director
M
(who has been with the company for several years) during last years budget-setting process. These
forecasts are 3,800,000 for Quarter 3 and 3,600,000 for Quarter 4.
As a basis for revising the sales forecasts for the two remaining quarters of 2003, the management
accountant of Storrs plc has begun to apply time series analysis in order to identify the seasonal variations
A
in sales. He has so far calculated the following centred moving averages, using a base period of four
quarters.
Year Quarter 1 Quarter 2 Quarter 3 Quarter 4
C
2001 3,200,000 3,300,000
2002 3,375,000 3,450,000 3,562,500 3,687,500
Required:
(a) Using the sales information and centred moving averages provided, and assuming an additive
model, forecast the sales of Storrs plc for Quarter 3 and Quarter 4 of 2003, and comment on the
sales forecasts made by the sales director.
Q4. The Western is a local government organisation responsible for waste collection from domestic
households. The new management accountant of The Western has decided to introduce some new
forecasting techniques to improve the accuracy of the budgeting. The next budget to be produced is for
the year ended 31 December 2010.
Waste is collected by the tonne (T). The number of tonnes collected each year has been rising and by
using time series analysis the new management accountant has produced the following relationship
between the tonnes collected (T) and the time period in question Q (where Q is a quarter number. So Q =
1 represents quarter 1 in 2009 and Q = 2 represents quarter 2 in 2009 and so on)
T = 2,000 + 25Q
Each quarter is subject to some seasonal variation with more waste being collected in the middle quarters
of each year.
Page 82 of 106
The adjustments required to the underlying trend prediction are:
Quarter Tonnes
1 200
2 +250
3 +150
4 100
Once T is predicted the new management accountant hopes to use the values to predict the variable
operating costs and fixed operating costs that The Western will be subjected to in 2010. To this end he
has provided the following operating cost data for 2009.
Volume of waste Total operating cost in 2009
Tonnes $000s
s
2,100 950
2,500 1,010
2,400 1,010
e
2,300 990
Inflation on the operating cost is expected to be 5% between 2009 and 2010.
The regression formula is shown on the formula sheet.
Required:
e
(a) Calculate the tonnes of waste to be expected in the calendar year 2010.
n
(4 marks)
(b) Calculate the variable operating cost and fixed operating cost to be expected in 2010 using
regression analysis on the 2009 data and allowing for inflation as appropriate. (10 marks)
Many local government organisations operate incremental budgeting as one of their main budgeting
techniques. They take a previous periods actual spend, adjust for any known changes to operations and
A
then add a % for expected inflation in order to set the next periods budget.
(c) Describe two advantages and two disadvantages of a local government organisation funded by
taxpayers money using incremental budgeting as its main budgeting technique. (6 marks)
a
Q5. Northlands major towns and cities are maintained by local government organisations (LGO), which
are funded by central government. The LGOs submit a budget each year which forms the basis of the
r
funds received.
i
You are provided with the following information as part of the 2010 budget preparation.
Overheads
Overhead costs are budgeted on an incremental basis, taking the previous years actual expenditure and
a
adding a set % to allow for inflation. Adjustments are also made for known changes. The details for these
are:
Z
Note 1: One new staff member will be added to the overhead team; this will cost $12,000 in 2010
Note 2: A move towards the paperless office is expected to reduce stationery costs by 40% on the 2009
spend Road repairs. In 2010 it is expected that 2,000 metres of road will need repairing but a contingency
of an extra 10% has been agreed.
In 2009 the average cost of a road repair was $15,000 per metre repaired, but this excluded any cost
effects of extreme weather conditions. The following probability estimates have been made in respect of
2010:
Page 83 of 106
Inflation on road repairing costs is expected to be 5% between 2009 and 2010.
New roads
New roads are budgeted on a zero base basis and will have to compete for funds along with other capital
projects such as hospitals and schools.
Required:
(a) Calculate the overheads budget for 2010. (3 marks)
(b) Calculate the budgets for road repairs for 2010. (6 marks)
(c) Explain the problems associated with using expected values in budgeting by an LGO and explain
why a contingency for road repairs might be needed. (8 marks)
(d) Explain the process involved for zero based budgeting. (3 marks)
(20 marks)
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A
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Theory of Budgeting
Why planning is necessary (budgeting)
i) Organisations formulate plans in order to achieve their objectives. Corporate or strategic planning
is concerned with determining the direction in which the organisation is expected to move and with
setting objectives to support this.
ii) Achievement of longer-term objectives is supported in the shorter term by the budgetary
planning process, which gives rise to the short-term financial plan known as a budget. Annual
budgets, therefore, are the means by which organizations implement their long-term or strategic
plan.
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iii) Budgetary planning requires the identification of the principal budget factor, which is the
limiting factor as far as the organisations activities are concerned. This limiting factor is usually sales
volume in commercial organisations and so budget preparation would begin with formulating the
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sales budget. Where some other factor is limiting the organisations activities, such as production
capacity, achievement of strategic plans may call for financial investment in new machinery in order to
remove this limiting factor.
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iv) Once the principal budget factor and its associated budget have been prepared, functional
budgets and the master budget can be prepared. In a large organisation the preparation of these
budgets will require planning and co-ordination between different aspects or areas of the business,
since otherwise the budget might contain elements that are unrealistic or not achievable.
v) In supporting planning and co-ordination, the budgetary planning process also supports
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communication between different areas of the organisation. Each area will become aware of the
long-term objectives of the organisation, the role that it is expected to play in achieving those
objectives in the short-term through the annual budget, and the way in which different areas of the
organisation need to work together during the budget period.
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vi) While annual budgets give structure and direction to organisational activity, regular monitoring
of actual performance is needed in order to determine whether planned performance is being
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achieved. The detailed comparison of planned with actual performance can indicate where the
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organisation needs to take action in order to ensure that the annual budget is achieved. By achieving
the annual budget, the organisation will be meeting its long-term objectives. Although it is possible
that changes in the environment of the organisation may mean that some elements of the budget are
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no longer appropriate, the budgetary control process can accommodate these environmental
changes by amending the budget in order to support the continuing achievement of organisational
objectives.
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vii) Another way in which budgetary planning and control can help organisations to achieve their
objectives is by motivating employees to achieve those objectives. This motivation can arise
through participation in the budgetary planning process, through setting budget targets which have a
motivational effect on employees, through employee satisfaction at meeting periodic budget targets,
and by using performance against budget as the basis for employee rewards. An organisation will also
expect that managers do not perform poorly in the organisational areas for which they are
responsible, since this undermines the achievement of both short-term and long-term organisational
objectives, and managerial performance can be evaluated against agreed budget targets in order to
identify such managers.
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Key stages in the planning process / control cycle
The key stages in the planning process that links long-term objectives and budgetary control can be
divided between long-term planning and the budgeting process. Long-term planning involves
identifying objectives, and identifying, evaluating and selecting alternative courses of action. The
budgeting process involves implementing the long-term plan in the annual budget, monitoring actual
results and responding to divergences from plan
i) Identifying objectives
The planning process cannot take place unless organisational objectives are identified, since these
determine what the organisation is seeking to accomplish through its operations and activities. These
objectives will be long-term or strategic in nature and will give direction to the organisations
operational activities.
ii) Identifying alternative courses of action
Once organisational objectives have been identified, alternative courses of action that may lead to
achieving those objectives can be identified. Strategic analysis of the organisation and its environment
can indicate potential courses of action. For example, a company may look at its existing products and
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markets, its potential markets, the threat posed by its competitors, the impact of changes in
technology on its products and production processes, and so on, and decide that a key objective is
the development of new products to replace existing products in existing markets that are reaching
the end of their product life cycle.
iii) Evaluating alternative courses of action
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At this stage the various alternative courses of action are considered from the point of view of
suitability, feasibility and acceptability. In order for this to be done, detailed information about each
alternative course of action needs to be gathered and analysed.
iv) Selecting alternative courses of action
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Once the most appropriate alternative courses of action have been selected, long-term plans to
implement them are formulated. Because these plans are long-term in nature, they will of necessity be
less detailed than short-term plans, and will need to allow a degree of flexibility in responding to the
changing organisational environment.
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Preparing and implementing the budget
A budget is a short-term plan formulated in financial terms and will show in detail the short-term
actions the organisation will take in working towards its long-term objectives. Once the budget has
been formulated, finalised and agreed it can be implemented.
Monitoring actual results
In order to achieve the long-term objectives that are reflected in the budget, the organisation must
ensure that actual performance is proceeding according to plan. It will therefore need to monitor
actual performance and results.
Responding to divergences from plan
Divergences from planned activity, as measured by variances from budget, can lead to action if they
are deemed to be significant. This action may be corrective in nature, in order to bring actual activity
back into line with planned activity, or may entail revision of the budget if one of its underlying
assumptions is seen as being in error.
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Approaches of making budgets
Top down budget

A top down (or authoritative or non- participative) approach to budgeting involves preparation of
budgets by senior managers without giving the ultimate budget holder an opportunity to participate
in the budgeting process. These budgets are then passed down to (imposed upon) budget holders.
This approach has the following advantages:
It gives senior management better control of the business.
It should lead to tactical decisions that are in line with the overall strategic plan (goal congruence).
It reduces the opportunity for junior managers to build slack (padding) into budgets.
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Depending upon the abilities and experience of senior and junior managers it could be argued to
produce better quality decisions.
Budgets should be prepared more quickly than under other approaches.
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Disadvantages of participative budgets:
- Less sense of ownership of standards
- Standards can be inappropriate because labour know production process well
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- Labour might get demotivated
Bottom up budget
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A system of budgeting in which budget holders have the opportunity to participate in setting their
own budgets. Also called participative budgeting. Even here budgets prepared by junior managers
would be reviewed and challenged by senior management.
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Advantages of participative or bottom up budgets:
Increased motivation (ownership of budget)
Should contain better information, especially in a fast-moving or diverse business
Increases managers understanding and commitment
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Better communication
Senior managers can concentrate on strategy
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Disadvantages of participative budgets:
Senior managers may reset loss of control
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Bad decisions from inexperienced managers
Budgets may not be in line with corporate objectives as managers lack a strategic perspective and
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will focus just on divisional concerns
Budget preparation is slower and disputes can arise
Figures may be subject to bias if junior managers either try to impress or set easily achievable
targets (budgetary slack)
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Certain environments may preclude participation, e.g. sales manager may be faced with long term
contracts already agreed.
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Rolling budgets
A budget kept continuously up to date by adding another accounting period (e.g. month or quarter)
when the earliest accounting period has expired.
Aim: to keep tight control and always have an accurate budget for the next 12 months.
Advantages of rolling budgets:
The budgeting process should be more accurate
There should be much better information upon which to appraise the performance of
management
The budget will be much more relevant by the end of the traditional budgeting period
It forces management to take budgeting process more seriously.
Disadvantages of rolling budgets:
They are more costly and time consuming
An increase in budgeting work may lead to less control of the actual results
There is a danger that the budget may become the last budget plus or minus a bit
Incremental budgets
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An incremental budget starts with the previous periods budget or actual results and adds (or
subtracts) an incremental amount to cover inflation and other known changes.
Advantages:
Quickest and easiest method
Assuming that the historic figures are acceptable, only the increment needs to be justified
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Avoids reinventing the wheel
Disadvantages:
Builds in previous problems and inefficiencies, e.g. an overspend may result on a larger budget
allowance next year
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Uneconomic activities maybe continued, e.g. the firm may continue to make a component in-
house when it might be cheaper to outsource.
Managers may spend unnecessarily to use up their budgeted expenditure allowance this year,
thus ensuring they get the same (or a larger) budget next year.

Activity-based budgeting
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It is a method of budgeting based on an activity framework and utilizing cost driver data in
the budget-setting and variance feedback processes.
Advantages of ABB:
It draws attention to the costs of overhead activities. This can be important where overhead costs are
a large proportion of total operating costs.
It provides information for the control of activity costs, by assuming that they are variable, at least in
the longer term.
It provides useful control information by emphasizing that activity costs might be controllable if the
activity volume can be controlled.
ABB can provide useful information for a total quality management (TQM) programme, by relating the
cost of an activity to the level of service provided (for example, stores requisitions processed) do
the user departments feel they are getting a cost- effective service?
It provides a useful basis for monitoring and controlling overhead costs, by drawing management
attention, to the actual costs of activities and comparing actual costs with what the activities were
expected to cost.
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Disadvantages of ABB
A considerable amount of time and effort might6 be needed to establish an ABB system, for example
to identify the key activities and their cost drivers.
ABB might not be appropriate for the organization and its activities and cost structures.
A budget should be prepared on the basis of responsibility centers, with identifiable budget holders
made responsible for the performance of their budget center. A problem with ABB could be to
identify clear individual responsibilities for activities.
It could be argues that in a short- term many overhead costs are not controllable and do not vary
directly with changes in the volume of activity for the cost driver. The only cost variances to report
would be fixed overhead expenditure variances for each activity.
Zero-based budgeting
e s
Zero-based budgeting requires that activities be re-evaluated as part of the budget process so that each
activity, and each level of activity, can justify its consumption of the economic resources available. This is
in contrast to incremental budgeting, where the current budget is increased to allow for expected future
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conditions.
Zero-based budgeting prevents the carrying forward of past inefficiencies that can be a feature of
incremental budgeting and focuses on activities rather than departments or programmes. Each activity is
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treated as though it was being undertaken for the first time and is required to justify its inclusion in the
budget in terms of the benefit expected to be derived from its adoption.
The first step in zero-based budgeting is the formulation of decision packages. These are documents
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which identify and describe a given activity or group of activities in detail. The base package represents
the minimum level of activity that is consistent with the achievement of organisational objectives.
Incremental packages describe higher levels of activity which may be delivered if they are acceptable from
a cost-benefit perspective.
Following the formulation of decision packages, they are evaluated by senior management and ranked by
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decreasing benefit to the budgeting organisation. Resources should then be allocated, theoretically at
least, to decision packages in order of decreasing marginal utility until all resources have been allocated.
Advantages for zero-based budgeting
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The advantages of ZBB are:
i) Identification and elimination of unnecessary expenditure. Activities that do not contribute toward
organizational objectives will be discontinued.
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ii) Identification of wasteful expenditure. Overspending on activities will be identified and budgets will be
reduced accordingly.
iii) It challenges the status quo and encourages a questioning approach to activities and expenditure. In
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this way it is the ideal antidote for incremental budgeting.
iv) The documentation that ZBB requires provides an in depth appraisal of an organisations activities.
v) It provides a plan to work to (in service departments) if more funds become available.
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Article on budgeting
The budgeting process is an essential component of management control systems, as it provides a system
of planning, coordination and control for management. It is often an arduous process, however, and often
strikes dread in the hearts of those involved in budget preparation.
In the public sector, the budgeting process can be even more difficult, since the objectives of the
organisation are more difficult to define in a quantifiable way than the objectives of a private company.
For example, a private company's objectives may be to maximise profit. The meeting of this objective can
then be set out in the budget by aiming for a percentage increase in sales and perhaps the cutting of
various costs. If, on the other hand, you are budgeting for a public sector organisation such as a hospital,
then the objectives may be largely qualitative, such as ensuring that all outpatients are given an
appointment within eight weeks of being referred to the hospital. This is difficult to define in a
quantifiable way, and how it is actually achieved is even more difficult to define.
This leads onto the next reason why budgeting is particularly difficult in the public sector. Just as
objectives are difficult to define quantifiably, so too are the organisation's outputs. In a private company
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the output can be measured in terms of sales revenue, for example. There is a direct relationship between
the expenditure that needs to be input in order to achieve the desired level of output. In a hospital, on the
other hand, it is difficult to define a quantifiable relationship between inputs and outputs. What is easier
to compare is the relationship between how much cash is available for a particular area and how much
cash is actually needed. Therefore, budgeting naturally focuses on inputs alone, rather than the
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relationship between inputs and outputs.
The purpose of this article is to critically evaluate the two main methods for preparing budgets - the
incremental approach and the zero-based approach. Both of these have been used in both public sector
and private sector organisations, with varying degrees of success.
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Incremental budgeting
Incremental budgeting is the traditional budgeting method whereby the budget is prepared by taking the
current period's budget or actual performance as a base, with incremental amounts then being added for
the new budget period. These incremental amounts will include adjustments for things such as inflation,
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or planned increases in sales prices and costs. It is a common misapprehension of students that one of the
biggest disadvantages of incremental budgeting is that it doesn't allow for inflation. Of course it does; by
definition, an 'increment' is an increase of some kind. The current year's budget or actual performance is a
starting point only.
Example
A school will have a sizeable amount in its budget for staff salaries. Let's say that in one particular year,
staff salaries were $1.5m. When the budget is being prepared for the next year, the headteacher thinks
that he will need to employ two new members of staff to teach languages, who will be paid a salary of
$30,000 each (before any pay rises) and also, that he will need to give all staff members a pay increase of
5%. Therefore, assuming that the two new staff will receive the increased pay levels, his budget for staff
will be $1.638m [($1.5m +$30k + $30k) x 1.05]
It immediately becomes apparent when using this method in an example like this that, while being quick
and easy, no detailed examination of the salaries already included in the existing $1.5m has been carried
out. This $1.5m has been taken as a given starting point without questioning it. This brings us onto the
reasons why incremental budgeting is not always seen as a good thing and why, in the 1960s, alternative
methods of budgeting developed. Since I thoroughly believe that Paper F5 students should always go into
the exam with their metaphorical F5 toolbox (see related article by Ann) in their hand, pulling tools out of
Page 90 of 106
the box as and when they need them in order to answer questions, I am going to list the benefits and
drawbacks of both budgeting methods in a easy-to-learn format that should take up less room in the
'box'. The problem I often find with Paper F5 students is that they think they can go into the exam without
any need for such a toolbox, and while they may be able to get through some of the numerical questions
simply from remembering techniques that they have learnt in the past, when it comes to written
questions, they simply do not have the depth of knowledge required to answer them properly.
Benefits of incremental budgeting
As indicated above, it is easy to prepare and is therefore quick. Since it is easy to prepare, it is also
easily allocated to more junior members of staff.
As well as being easy to prepare, it is easy to understand.

Less preparation time leads to lower preparation costs.
Prevents conflict between departmental managers since a consistent approach is adopted
throughout the organisation.
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The impact of change can be seen quickly. For example, the increase of $138k in staff costs for the
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aforesaid school can quickly be traced back to the employment of two new staff members and a
5% pay increase because everything else in the staff salaries budget remained unchanged.
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Drawbacks of incremental budgeting
It assumes that all current activities and costs are still needed, without examining them in detail. In our
school example above, we know that the headteacher has budgeted for two new language teachers.
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How carefully has he looked into whether both of these new teachers are actually needed? It may be
that, with some timetable changes, the school could manage with only one new teacher, but there is
no incentive for the headteacher to actually critically assess the current costs of $1.5m (provided, of
course, that the funding is available for the two new teachers).
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With incremental budgeting, the headmaster does not have to justify the existing costs at all. If he can
simply prove that there is an increase in the number of language lessons equivalent to two new staff's
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teaching hours, he can justify the cost of two new teachers.By its very nature, incremental budgeting
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looks backwards rather than forwards. While this is not such a problem is fairly stable businesses, it
will cause problems in rapidly changing business environments.
There is no incentive for departmental managers to try and reduce costs and in fact, they may end up
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spending money just for the sake of it, knowing that if they don't spend it this year; they won't be
allocated the cash next year, since they will be deemed not to need it.
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Performance targets are often unchallenging, since they are largely based on past performance with
some kind of token increase. Therefore, managers are not encouraged to challenge themselves and
inefficiencies from previous periods are carried forward into future periods. In our school example
above, the headteacher may have hired an extra cook for the school kitchen when he thought that
there was going to be greater demand for school dinners than there actually turned out to be. One of
the cooks may be sitting idle in the kitchen most of the time but, with no-one looking at the existing
costs, it is unlikely to change.
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Time for change
After World War II, when money was tighter than ever, the problems with incremental budgeting began to
give rise to a feeling that change was needed. By the 1960s, something called 'programme budgeting'
began to develop in the US, introduced by the then US Secretary of Defence. This budgeting system
requires objectives, outputs, expected results and then detailed costs to be given for every activity or
program. Only when all of the budgets are then put together for all of the activities is the 'programme
budget' then complete. This budgeting system requires a degree of transparency never before seen under
incremental budgeting systems and, as you can imagine, it was not welcomed by the public sector at
whom it was largely aimed. Therefore, it was closely followed by the development of zero-based
budgeting. Zero-based budgeting emerged first in the public sector in the 1960s, but it also gained
popularity in the private sector and was adopted by Texas Instruments in 1969. It gained notoriety in the
1970s when US President Jimmy Carter introduced it in the state of Georgia. While I could talk at more
length about the history of zero-based budgeting, it's not particularly relevant for the Paper F5 exam, so I
won't. Let's face it, you have already got enough to learn, and I don't need to add to it!
Zero-based budgeting (ZBB)
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With zero-based budgeting, the budgeting process starts from a base of zero, with no reference being
made to the prior period's budget or actual performance. All of the budget headings, therefore, literally
start with a balance of zero, rather than under incremental budgeting, when they all start with a balance at
least equal to last year's budget or spend. Every department function is then reviewed comprehensively,
with all expenditure requiring approval, rather than just the incremental expenditure requiring approval.
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Zero-based budgeting tries to achieve an optimal allocation of resources to the parts of the business
where they are most needed. It does this by forcing managers to justify every activity in their department
as they know that, until they do this, the budget for their department is zero. If they are unable to do this,
they aren't allocated any resources and their work therefore stops (as does their employment within the
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organisation, at this point, presumably). In this way, all unjustifiable expenditure theoretically ceases. A
questioning attitude is developed by management, who are constantly forced to ask themselves questions
such as:
Is the activity really necessary at all?
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What happens if the activity ceases?
Is the current level of provision adequate?
What other ways are there of carrying out the activity?
How much should the activity cost?
Do the benefits to be gained from the activity at least match the costs?
All of these questions are largely answered by breaking the budgeting process down into three distinct
stages, as detailed below.
Stages in zero-based budgeting
1. Activities are identified by managers. Managers are then forced to consider different ways of
performing the activities. These activities are then described in what is called a 'decision package', which:
analyses the cost of the activity
states its purpose
identifies alternative methods of achieving the same purpose
establishes performance measures for the activity
assesses the consequence of not performing the activity at all or of performing it at different levels.
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As regards this last point, the decision package may be prepared at the base level, representing the
minimum level of service or support needed to achieve the organisation's objectives. Further incremental
packages may then be prepared to reflect a higher level of service or support.
For example, if ZBB was used by our headteacher in our example above, one of the activities that would
have to be performed would be the provision or facilitation of school lunches. The school catering
manager may consider three options. Option 1: providing an area where students can bring their own
cold food to, with some sandwiches and other cold food and drinks being prepared and sold by catering
staff. Option 2: providing a self-service cafeteria with hot and cold food and drinks available. Option 3:
providing a full, hot food, catered service for pupils. The base level of service would be option 1, with
options 2 and 3 being higher level service options. The school may, on the other hand, consider two
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mutually exclusive decision packages - providing a service internally or outsourcing the whole catering
activity to an external provider.
While some form of cost-benefit analysis may be useful at this stage, a degree of quantitative analysis
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must also be incorporated. For example, cost-benefit analysis may show that the minimal level of
provision for the school (option 1) is the most cost-effective. However, this would present the school in a
negative light to parents of potential pupils and would deter some parents from sending their children to
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that school. Consequently, more able students may be discouraged from applying, thus leading to poorer
results which, in turn, could have a negative impact on the school's future funding. Simple cost-benefit
analysis would find it difficult to incorporate the financial effect of such considerations.
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2. Management will then rank all the packages in the order of decreasing benefits to the organisation.
This will help management decide what to spend and where to spend it. This ranking of the decision
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packages happens at numerous levels of the organisation. For example, in the case of the school, the
catering manager will rank the numerous decision packages that he prepares. Then, the headmaster will
rank the catering packages amongst all the packages prepared for the rest of the school.
3. The resources are then allocated based on order of priority up to the spending level.
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Benefits of ZBB
The benefits of ZBB are substantial. They would have to be otherwise no organisation would ever go to
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the lengths detailed above in order to implement it. These benefits are set out below:
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Since ZBB does not assume that last year's allocation of resources is necessarily appropriate for the
current year, all of the activities of the organisation are re-evaluated annually from a zero base. Most
importantly therefore, inefficient and obsolete activities are removed, and wasteful spending is

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curbed. This has got to be the biggest benefit of zero-based budgeting compared to incremental
budgeting and was the main reason why it was developed in the first place.
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By its nature, it encourages a bottom-up approach to budgeting in order for ZBB to be used in
practice. This should encourage motivation of employees.
It challenges the status quo and encourages a questioning attitude among managers.
It responds to changes in the business environment from one year to the next.
Overall, it should result in a more efficient allocation of resources.
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Drawbacks of ZBB
Departmental managers may not have the necessary skills to construct decision packages. They
will need training for this and training takes time and money.
In a large organisation, the number of activities will be so large that the amount of paperwork
generated from ZBB will be unmanageable.
Ranking the packages can be difficult, since many activities cannot be compared on the basis of
purely quantitative measures. Qualitative factors need to be incorporated but this is difficult. Top
level management may not have the time or knowledge to rank what could be thousands of
packages. This problem can be somewhat alleviated by having a hierarchical ranking process,
whereby each level of managers rank the packages of the managers who report to them.
The process of identifying decision packages and determining their purpose, costs and benefits is
massively time consuming and costly. One solution to this problem is to use incremental
budgeting every year and then use ZBB every three to five years, or when major change occurs.
This means that an organisation can benefit from some of the advantages of ZBB without an
annual time and cost implication. Another option is to use ZBB for some departments but not for
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others. Certain costs are essential rather than discretionary and it could be argued that it is
pointless to carry out ZBB in relation to these. For example, heating and lighting costs in a school
or hospital are expenses that will have to be paid, irrespective of the budget amount allocated to
them. Incremental budgeting would seem to be more suitable for costs like these, as with
building repair costs.
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Since decisions are made at budget time, managers may feel unable to react to changes that
occur during the year. This could have a detrimental effect on the business if it fails to react to
emerging opportunities and threats.
The organisation's management information systems might be unable to provide the necessary
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information.
It could be argued that ZBB is far more suitable for public sector than for private sector organisations. This
is because, firstly, it is far easier to put activities into decision packages in organisations which undertake
set definable activities. Local government, for example, have set activities including the provision of
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housing, schools and local transport. Secondly, it is far more suited to costs that are discretionary in
nature or for support activities. Such costs can be found mostly in not for profit organisations or the
public sector, or in the service department of commercial operations.
Conclusion
Since ZBB requires all costs to be justified, it would seem inappropriate to use it for the entire budgeting
process in a commercial organisation. Why take so much time and resources justifying costs that must be
incurred in order to meet basic production needs? It makes no sense to use such a long-winded process
for costs where no discretion can be exercised anyway. Incremental budgeting is, by comparison, quick
and easy to do and easily understood. However, the use of incremental budgeting indisputably gives rise
to inefficiency, inertia and budgetary slack.
In conclusion, neither budgeting method provides the perfect tool for planning coordination and control.
However, each method offers something positive to recommend it and one cannot help but think that the
optimal solution lies somewhere between the two.
Ann Irons is examiner for Paper F5
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BEHAVIOURAL ASPECTS OF BUDGETING
RELEVANT TO ACCA QUALIFICATION PAPER F5
A budget can be defined as a quantified plan relating to a given period. Although budgets are often
stated in terms of money, they need not be, and can also relate to quantities made and sold, numbers of
employees to be recruited, or weights of material to be consumed. Quantification is important because it
adds precision and clarity to a plan. However, it can cause problems as budgets inevitably end up being
human obligations and we worry about how the budget was determined, if it is fair, what happens if we
fail, are there political dimensions to it, should we cheat, or will account be taken of factors outside our
control? Perhaps most importantly, how are we to reconcile the pressure to achieve short-term budgets
(usually carefully monitored) with ambitions for long-term improved performance which may not be
successfully captured by financial statements?
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Budgets should not be conjured up out of thin air. Without getting too far into the details of long term
strategic planning, organisations will have ambitions which should take into account the wider
environment (for example, what is happening in the economy), their markets (for example, what their
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competitors are doing), and their products (perhaps a certain product is old and its sales declining). This
information, often speculative, should allow an organisation to plot its long-term future and then it can
dissect this long-term objective into detailed, shorter-term plans. These plans are usually communicated
through budgets: what volume of sales do we hope for, what will power costs be, how many employees
will we need, what corporation tax will be levied by the government?
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This article looks at three aspects of budgeting, though there is considerable cross over between them:
the purposes of a budgets, including motivation and evaluation
budgets as objectives
how to set a budget.
THE PURPOSE OF A BUDGET

Budgets can accomplish the following:
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Forecasting
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Inevitably, if an organisation is going to draft a budget which will be of any use whatsoever, it will have to
make forecasts. These forecasts will not always be correct, but at least the organisation has had to look
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ahead. It wont see every danger or opportunity, but looking ahead must be better than moving forward
with eyes closed.
Forecasts are often based on the results of previous periods, updated for known changes. Statistical
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methods are sometimes used to forecast seasonal effects. Occasionally, specialist data might be
purchased to help organisations take economic effects into account as economies improve or deteriorate.
Organisations need to beware of forecasts becoming self fulfilling prophecies. For example, if a downturn
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is anticipated, and because of that sales budgets are cut thus reducing employees' ability to sell, then
there will be a downturn in sales. We will discuss later the difficult issue of budgets which motivate as
opposed to a budget which we hope to achieve.
Planning
Once forecasts are completed, planning can be carried out. For example, if the forecast suggests a
dramatic increase in demand, then new production facilities might have to be planned. However, it is
important to be aware at the planning stage that the forecasts might not be correct, or even if they were
correct at the time they were made, things can change. Detailed planning might even require the
forecasting stage to be revisited to check estimates or to try to gather more evidence for estimates. Even
if forecasting does not have to be reviewed, planning should, as far as possible, remain flexible, just in
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case the forecast isnt fulfilled. So, perhaps instead of acquiring new production facilities, it might be
better to hire or subcontract initially to see if the forecast is right. If it is, then the organisation can go
ahead and buy production facilities for the following period.
The planning of cash flows is particularly important. Cash flow forecasts are routinely produced but the
organisation which believes them unconditionally will have a short life. Plan for possible shortfalls; build in
flexibility; have short term financing facilities planned and on call should things not turn out as well as
expected.
Coordination
In many ways, coordination is an aspect of planning (making sure the company delivers what it has
budgeted to sell), but it is worthy of a separate mention. What this heading really highlights is that there
has to be a match between the organisations structure and ambition and the requirements for its success.
In some businesses it is important to meet well-understood customer demands quickly and reliably, and
in this context, strict budget targets and measurement can be vital to success. Other businesses might
find that flexibility, adaptability and technical innovation are more important. If you dont know what
customers require, then setting targets through budgets is less applicable and might even be counter-
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productive because it can limit responses: its not in the budget, so we cant do it.
Communication
A budget is a succinct and precise way of communicating targets to departments and employees or at
least some aspects of what should be achieved. The problem is not what is specified in the budget, its
whats not specified. The budget might state explicitly that 2,000 units should be made in a period, but
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implicit in the target is that the units should be of a certain quality. The budget might be explicit about
the labour rate per hour to be paid, but might not specify the skills that employees should have.
Unfortunately, but inevitably, employees will take most notice of explicit requirements and are liable to
downgrade other important but unspecified factors. Of course, a lot will depend on how the budgets are
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imposed and how results are interpreted, but it is important for budgets to communicate requirements as
comprehensively as possible.
Authorisation
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A budget can be an authorisation to spend, and can, therefore, be a powerful way of delegating power
within an organisation. For example, once you give a department a capital expenditure budget you then
let that department get on with it, buying new equipment as it sees fit. The only alternative is to have the
departmental head keep coming back for permission for bits and pieces of expenditure. Of course, before
the budget is given to the department, that department needs to make a case for the expenditure. It will
put forward arguments as to why it needs certain capital expenditure (as will other departments), and the
budget committee that oversees the budgeting process will have coordinated matters as best it can. So
the budget represents pre-authorised expenditure and combines delegation to spend with restraints as to
the maximum that should be spent.
Motivation
A budget represents a target, and aiming towards a target can be a powerful motivator. However, whether
the target will actually cause employees to do better is thought to depend on how difficult the target is
perceived to be. Employees have different perceptions of targets, but generally it is thought that:
if targets are very low, actual performance can be pulled down from where it might naturally have
been
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if targets are habitually very high, then employees might give up and, again, performance can be
reduced if you know that no matter how hard you try you will fail to meet the target, its easy to
conclude that you might as well not try at all.
So, the aim is to set budgets which are perceived as being possible, but which entice employees to try
harder than they otherwise might have done. Of course, two employees can look at the same budget and
have quite different impressions about how difficult it is, but we are unlikely to develop individual budgets
tailored to individual psychologies. The concept of a motivating budget, however, is a powerful one,
although the budget which is best for motivating might not represent the results which are actually
expected. Managers can, and perhaps should, build in a margin for noble failure.
The relationship between budget difficulty and actual performance is typically represented in Figure 1,
which shows the following:
s
When the budget is very easy, actual performance is low. It has been pulled down by the low
demands made of employees.
When the budget is very difficult, actual performance is low. Why try when you are doomed to
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failure?
When a budget is set at the level of the expectations (the best estimate of what performance
will actually be), employees are likely to perform as expected.
e
If a more difficult aspirational budget is set, employees will try harder, and if the budget is
judged just right then their actual performance will be at its maximum, though often falling short
of the budget.
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The last situation can give rise to whats known as the bottom drawer phenomenon. Managers issue a
public, motivational budget, but then have a secret budget (kept in the bottom drawer) which more
accurately reflects what they think will actually happen. One is forced to wonder what happens to
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motivation when the existence of the hitherto secret budget becomes known. What baroque dance of
bluff and counter bluff will occur?
Evaluation
Once budgets have been set as performance targets, inevitably performance will be evaluated. This can be
simply a comparison of actual with budgeted performance or alternatively can be a more elaborate
comparison of actual performance with flexed budget performance, as is found in variance analysis and
operating statements. The evaluation stage is often one of the most contentious as it is here that
performance is likely to be criticised and employees will be sensitive. There are many potential difficulties:
The budget might simply have been wrong, unachievable from the outset.
The budget might have become unachievable as the period progresses.
Departments performances could interfere with each other's.
Elements of the budget could be incompatible so meeting one target means missing another.
Although the right decision was made for long-term profitability, this had an adverse effect on
the short-term budget.
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Hopwood1 identified three distinct ways of using budget information when evaluating performance:
1. Budget constrained style. Here, an employee's performance is primarily judged on their ability to
continuously meet their budgets on a short-term basis. This criterion is held to be more important than all
other desirable outcomes. So, for example, over-spending to get a machine repaired quickly so that an
important order is shipped would be criticised because the repair budget was exceeded. Not surprisingly,
this approach leads to very poor managersubordinate relationships and also encourages the manipulation
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and misreporting of information.
2 The profit conscious style. Here, employees are primarily judged on their ability to increase the
long-term effectiveness of their departments. Budgets are not ignored, but they are regarded more as
guidelines than strict targets and are interpreted flexibly. In the above example, the employee would be
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more likely to be praised for getting the machine repaired as that enabled the organisation to meet
customer requirements.
3 Non-accounting style. Here, budgetary information does not play a big part in evaluation. Its
almost impossible to envisage any organisation which is not now subject to financial and therefore
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budgetary restraints, but from time to time there are elements of an organisations where money is
relatively unimportant. An example might be the budget required by an airline company to meet health
and safety requirements, because the consequences of not doing so would be disastrous.
BUDGETS AS OBJECTIVES
Budgets can obviously be used for setting organisational, departmental or individual objectives (or
targets). It is often said that, to be successful, objectives should be
SMART:
Specific or stated. Theres no point in simply telling a department to be better. No one quite knows
what is meant by better, so it is essential to be very specific about what is required, in terms such as units
sold, travelling expenses, or development costs.
Measurable. To be unequivocally communicated and later evaluated, measurement is essential and this
usually means trying to derive a quantitative measurement. Accountancy deals with quantitative measures
but that does not mean that accountancy holds all the secrets to successful operations. Quality of output
is very important, and is relatively easy to quantify, but routine accountancy documents, such as monthly
management accounts, do not usually report quality.
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Agreed/accepted/achievable. This desirable attribute of objectives relates to motivational budgets and
budget acceptance. Suffice to say that if an objective is not agreed or accepted, or not thought to be
achievable, it is unlikely to be very effective.
Relevant. Objectives must be seen as being relevant to the organisations purpose, whether that is to
make profits, or for a not-for-profit purpose such as curing the sick or educating children. If objectives
seem to have no connection with the higher purpose, then employees begin to feel that objectives are set
purely as exercises of managerial power ('I will give you this objective, not because it is useful or
necessary, but because it allows me to impose my will').
Time limited. Fairly obviously, if a time limit is not defined, objectives are unlikely to be effective.
The SMART approach to objectives and budgets may seem uncontroversial, but there are several
important behavioural aspects to take into consideration.
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First, more than one objective is needed. As mentioned under Communication, above, employees know
that whatever is set as an objective will be measured and will be used for performance evaluation.
Naturally, that is what they will therefore concentrate on, unfortunately often to the exclusion of other
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important aspects of performance. It is vital, therefore, to try to set objectives for all important measures
of
performance.
interest whatsoever to consumers.

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Second, not all aspects of desirable performance are easy to measure, but that doesnt mean you
shouldnt try and that you shouldnt set objectives. Remember, most accountancy measures are of no
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Consumers do not care much how much it costs to make something, or how long production takes, or the
cost of the machine on which the manufacturing was done. Consumers care about quality, reliable
delivery, innovation, style, and how the price of the item and its features compares with competing
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products. If consumers dont like what they see they wont buy, and conventional accountancy will give no
clues about why the organisation performs poorly.
Third, short-term budget pressures (measured meticulously) can muscle in on longerterm important
aspects of performance (poorly measured). The balanced scorecard approach of Kaplan and Norton, and
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the building block approach of Fitzgerald and Norton can be a great help in ensuring that objectives (or
targets), or budgets are set for a very wide range of factors, both financial and nonfinancial.
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Looking at the balanced scorecard in more detail, this approach considers a hierarchy of performance
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perspectives, as shown in Figure 2.
Z a
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Ultimately, businesses must perform well financially and there should be budget and objectives set for
measures such as return on capital employed, profit, growth, gross profit percentages and so on.
However, successful financial performance depends on pleasing customers and we should take care that
budgets and objectives take account of factors such as customer satisfaction, repeat business, or market
growth.
To do this, questions need to be asked such as:
Why do customers like us? Presumably because we are good at what we do, in terms of adequate stock-
holding, quality, efficient production, flexible responses to customer requests. Budgets should be set for
these because they are important.
How can we keep up with competitors and customer demands? Only through continual innovation,
improvement and learning. So the organisations financial success (easily and frequently measured by
budgets) ultimately depends on more nebulous matters such as innovation, quality, style, and flexibility.
Therefore, it is essential that budgets are set for these as well, otherwise they will be ignored as
employees strive to meet the often more superficial and short term conventional budget elements.
HOW TO SET A BUDGET
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Broadly, when setting a budget, there are two choices:
top down imposition
bottom up participation.
Organisations should look for the most effective way of setting their budgets:
How do they get employees to pay heed to a budget and to take it seriously?
How can they get accurate budgets?
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How can they motivate employees to try hard?
In management theory, participation in decision making, such as in budget setting, is usually seen as
bringing advantages to organisations. It allows information to be gathered from many sources, thereby
increasing the chance that all pertinent factors have been considered. Participation usually increases
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motivation and commitment as it is very difficult subsequently to ignore the decisions or targets which
one has helped develop. However, the demand and expectation for participation and consultation may
sometimes have more to do with the polemics of modern management than practical management,
because participation:
is time-consuming
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requires appropriate knowledge, skill and expectations
may involve selfish motives (for example, building slack into timescales and targets).
Participation undoubtedly has it uses, but it is not a cure for all organizational problems. One only has to
think of the difficult budgetary decisions that have had to be made by many organisations during the
current recession, where cut backs, redundancies and restraint have had to be imposed as a matter of
survival. As a result, there has recently been a swing back to more authoritative approaches to budget
setting and performance evaluation.
It is important to realise that the budget setting approach adopted for one department, for one set of
employees, or for one economic or competitive environment, is unlikely to be universally acceptable and
managers must be prepared to vary their approach to match the situation. This can be regarded as a
contingency (or best-fit) approach to budgeting where there is no single correct method. It depends on
the manager, the subordinates, the task and the environment.
Ken Garrett is a freelance writer and lecturer
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Standard Costing Analysis

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Standard Costing Analysis

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Section D

Standard Costing and Variances

felt he had to do something about it.

In month 2 the following data applies:

Material mix and yield variances with losses

Presentation soap packs purchased and used:

Standard costing can be used for

How to set standard

Z Factors to consider before investigation

Market share variance

Market size variance

(d) Pricing and Profitability

Q4. Jola Publishing Co publishes two forms of book.

Rates, rent supervision,

Details of two typical orders are shown below:

i) The modern manufacturing environment

ii) Activities and costs

iii) Improved cost control

iv) Better information on product profitability

Cost per factory hour =

Throughput accounting ratio =

Return per factory hour

Managing environmental costs

Defining environmental costs

Identifying environmental costs

bonuses more frequently.

Capital employed $15,00,000 $750,000

interpreting financial data

Profit maximisation in case of limiting factor

sometimes used to make decisions in uncertain situations.

Read examiner article on linear programming

r a Trend Seasonal variation

Year Quarter 1 Quarter 2 Quarter 3 Quarter 4

Top down budget

Zero-based budgeting (ZBB)

THE PURPOSE OF A BUDGET

interest whatsoever to consumers.

HOW TO SET A BUDGET

Ken Garrett is a freelance writer and lecturer

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